How to evaluate an ETF's tracking error?

Tracking error measures the deviation of an ETF's returns from its benchmark, which is influenced by factors such as sampling error, cash holdings, rebalancing, and index turnover.

Jan 06, 2025 at 11:20 pm

Key Points

• Understanding Tracking Error
• Causes of Tracking Error
• Metrics for Measuring Tracking Error
• Steps for Evaluating Tracking Error
• Impact of Tracking Error on Investment Strategies
• Best Practices for Minimizing Tracking Error

Understanding Tracking Error

Tracking error is a measure of how closely an exchange-traded fund (ETF) follows its underlying benchmark. It represents the volatility in the difference between the ETF's returns and the index it tracks. Tracking error is an important factor to consider when evaluating an ETF, as it can impact investment strategies and returns.

Causes of Tracking Error

Tracking error can occur due to various factors, including:

• Sampling Error: ETFs generally own a sample of assets from the underlying benchmark, which can lead to differences in returns.
• Cash Holding: ETFs may hold cash to meet redemption requests, which can deviate from the benchmark's composition.
• Rebalancing: ETFs need to periodically rebalance their portfolios to maintain alignment with the benchmark, which can introduce transactions costs and tracking error.
• Index Turnover: The underlying benchmark may change over time, leading to ETF portfolio adjustments and potential tracking error.

Metrics for Measuring Tracking Error

Several metrics can be used to measure tracking error:

• Root Mean Square Error (RMSE): Calculates the average difference between the ETF and benchmark returns.
• Tracking Error Standard Deviation: Measures the volatility of the difference between the ETF and benchmark returns.
• Information Ratio: Compares the tracking error to the excess return of the ETF over the benchmark.

Steps for Evaluating Tracking Error

Evaluating tracking error involves the following steps:

• Select a metric: Choose an appropriate metric to measure tracking error, such as RMSE or Information Ratio.
• Gather historical data: Collect data on the ETF's returns and the benchmark's returns over a sufficient time period.
• Calculate tracking error: Use the chosen metric to compute the tracking error for the ETF.
• Compare with industry benchmarks: Compare the tracking error to industry averages for similar ETFs.
• Consider investment strategy: Determine how tracking error aligns with the investment strategy being pursued.

Impact of Tracking Error on Investment Strategies

Tracking error can impact investment strategies in several ways:

• Reducing Diversification: Tracking error can increase the correlation between the ETF and its benchmark, reducing the benefits of diversification.
• Return Expectations: High tracking error can reduce the expected return of an ETF compared to the benchmark.
• Risk Management: Tracking error can contribute to portfolio volatility and impact risk management efforts.

Best Practices for Minimizing Tracking Error

To minimize tracking error, consider the following practices:

• Index Type: Choose ETFs that track broad-based indices with high correlation to the desired asset class.
• Expense Ratio: Consider lower-cost ETFs, as higher expense ratios can contribute to tracking error.
• Portfolio Size: ETFs with larger portfolios generally have lower tracking error due to reduced sampling error.
• Active Management: Some ETFs employ active management techniques to reduce tracking error by dynamically adjusting the portfolio.

FAQs

Q: What is a good tracking error percentage?
A: Tracking error depends on the ETF's investment objective and benchmark. Generally, ETFs with tracking errors below 1% are considered to be performing well.

Q: What causes tracking error to be higher for some ETFs than others?
A: Higher tracking error can result from factors such as higher cash holdings, frequent rebalancing, or specialized benchmarks with less liquid underlying assets.

Q: How can tracking error impact my investment portfolio?
A: High tracking error can increase portfolio risk, reduce diversification benefits, and lower investment returns.

Q: What other factors should I consider when evaluating an ETF's tracking error?
A: Consider the ETF's expense ratio, portfolio size, and liquidity to gain a comprehensive perspective on the tracking error's impact.