Exchange traded funds (ETFs) have become a very popular investment tool (Benefits Of ETFs) as investors have realized their numerous potential benefits over other types of investment vehicles. However, it is equally important to understand that sometimes they suffer from what are referred to as tracking errors.
Tracking errors are the differences between the performance of an ETF and the underlying index that it tracks, and in general, the less tracking error, the better. Here are four reasons tracking errors occur:
- Management Fees – In the ETF space, these are known as an ETF’s expense ratio and are taken directly out of net returns. Naturally, the higher the expense ratio, the larger the tracking error. Luckily, ETF expense ratios are generally lower than the expense ratios of mutual funds and are transparent to investors.
- Diversification Rules – The Securities and Exchange Commission (SEC) imposes strict diversification rules on ETFs, including one prohibiting an ETF from holding a single security comprising more than 25% of the ETF. For specialized or specific ETFs, at times, this can make it difficult for an ETF to track its index.
- Optimization Techniques – Some funds will buy only a subset of stocks that are in the underlying index in an attempt to provide performance similar to the index. This technique is generally done to lower trading costs or to get around position limits. The degree of optimization can affect the size of the tracking error.
- Dividend Drag – This occurs when there is cash in a fund. Since no major index is constructed with a cash component, when a dividend is paid on shares inside an ETF, there is a lag between receiving and reinvesting the cash. This error is generally very minimal, but it could potentially be a source of tracking error.
One way to get around tracking errors is through the use of ETNs (How To Use ETNs and ETFs), which are actually unsecured debt obligations of banks. ETNs don’t have to worry about tracking errors because their returns are not based on the underlying securities, but instead, the ETN issuer guarantees the ETN holder a return that is an exact replica of the underlying index, less fees.
Although ETNs get around the dilemma of tracking errors, they do come with an additional risk not found in ETFs; the credit risk of the debt issuer. In and of itself, tracking errors are a disadvantage of ETFs; but at the end of the day, the advantages of these transparent investment tools far outweigh any disadvantage (Why To Use ETFs).