ETF Tracking Error: What It Is and How It Happens

ETF Tracking Error: What It Is and How It Happens
December 09, 2009 at 1:00 pm by Tom Lydon
Exchange traded funds (ETFs) are useful tools in the investment world, but they are not without flaws. One such flaw many an investor may have heard about is tracking errors in ETFs.
All ETFs tend to have some tracking errors, and tracking errors can be either positive or negative, according to NobleTrading. The tracking errors are seen as a standard deviation from an ETF’s benchmark. (Reasons ETF tracking errors occur).
ETFs that seek to reflect broad indexes usually have lower tracking errors when compared to those reflecting certain sectors, indexes or foreign markets. Investors should note that ETF tracking errors are interpreted against its returns.
Let’s take a look at some of Noble Trading’s reasons ETF tracking errors:
Expense ratios. Specialty ETFs come with an active management ETF portfolio. The active management includes costs that result in tracking errors.
Portfolio optimization. At times, ETFs use samples since it is not possible to buy all stocks or securities of an index, which can give rise to tracking errors.
Lending fees. The total ETF return can be distorted by lending fees collected for hedge funds from short-selling.
Diversification constraints. Sector-specific ETFs may find it hard to perfectly mirror a sector because some companies make up a huge chunk of a sector, and ETFs aren’t allowed to invest more than a set percentage of assets in a single stock.
Cash holdings. Some ETFs require cash holdings to buy/sell securities.
Contango and backwardation. These two phenomena are associated with commodity ETFs, which may have roll futures that result in high tracking errors. (The four types of commodity ETFs).
Capital gains distributions and hedging risks. Both of these investment features could result in errors, as well.