4 Reasons ETF Tracking Error Occurs

Tracking errors in most exchange traded funds (ETFs) and exchange traded notes (ETNs) seemed to be relatively minuscule, enabling them to stay relatively close to indexes, despite the roller coaster ride of 2008.

Research from Morgan Stanley indicates that the average and weighted average tracking error for all U.S.-listed ETFs was 0.52% and 0.39%, respectively. On the downside, not all ETFs mimicked their indexes so closely.  In particular, the iShares FTSE NAREIT Mortgage REITs (REM) and Vanguard Telecom Services ETF (VOX) had larger negative tracking error.

John Spence of MarketWatch suggests some of the following reasons for possible negative tracking errors:

• Strict SEC diversification requirements
• A significant reduction in dividends of traditionally higher-yielding companies, which caused these companies to be left out of the index
• ETFs with bigger expense ratios have higher tracking errors because fees come directly out of investors’ bottom line
• Another factor is index optimization. Optimization is done when, for any number of reasons, replication is not possible: it would be too expensive to buy the index, there are limits on the number of shares a fund can own, the index is just too big and so on.

Unfortunately, tracking errors are inevitable.  After all, very few things are exactly alike.  On the plus side, these errors are not always a bad thing.  Sometimes it is indicative of ETFs being more diversified than the markets they represent.

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