Tracking in ETFs: What it is and why it matters
Marketing Communication
ETFs can be a relatively simple and cost-effective way to increase diversification1 in an investment portfolio. When you purchase an ETF, you gain exposure to multiple securities through a single transaction, without the hassle or expense of trading a large number of individual equities or bonds. ETFs are typically set up to track the performance of an index, made up of a group of stocks (also known as equities) or bonds (also known as fixed income). In short, ETFs consist of a range of assets intended to replicate a specific index.
ETFs are designed to track the performance of an index. Providers do so by mirroring the index composition with the fund’s investments.
The return of the fund is expected to reflect the return of the index. In practice, it is not quite so clear-cut as many aspects could impact performance.
So let’s look at two different metrics that could help you when considering an ETF.
In this example both ETFs have a similar tracking difference over the period: both start at 40 and end at 130. But they have distinct tracking errors:• ETF1 has a low tracking error and the index is properly replicated.• ETF2 has a high tracking error with an erratic performance profile: the index is poorly replicated by the asset manager.
Source: Amundi ETF, December 2024. For illustrative purpose only.
Tracking difference and tracking error explained
Although an ETF may hold the same equities or bonds as a particular index, their returns may not be exactly the same.
Tracking difference: Refers to the gap between the returns of the ETF and its index (i.e. it measures the overperformance or the underperformance of the ETF compared to its index). For example, if the 12-month return on an ETF was 10% but the index returned 10.2%, the tracking difference would be a -0.2%, fund underperformance versus the index.
Tracking error: shows whether the fund consistently performs similarly to the index by measuring how volatile the differences are between the fund’s and the index’s returns. Essentially, it reflects how much the gap between the ETF and the index fluctuates, rather than the size of the gap at a specific point in time. It measures the quality of the index replication: the lower it is the better the index replication.
How can these two tracking metrics help you in choosing an ETF?
It is common for an ETF to have a negative tracking difference when compared to its index for two main reasons:
As an ETF is a fund, like all funds, there is usually an ongoing management cost – if this cost is 0.2% a year, you would expect the tracking difference to be at least -0.2%.
The ETF may also incur transaction costs whenever equities or bonds are bought or sold in the ETF portfolio. Transaction costs are all the replication costs for the fund to buy the index components, including taxes, brokerage fees, bid-ask spreads and foreign exchange costs. These will have a negative impact on the relative performance of ETFs.
However, ETF managers could increase returns by temporarily lending equities or bonds to other investors: the gains received by securities lending then can help to offset the ETF’s ongoing management costs and transaction costs, and sometimes the ETF could show a final overperformance versus its index.
Although an ETF may hold the same equities or bonds as a particular index, their returns may not be exactly the same
The importance of tracking accuracy
To summarise, tracking difference may be negative (the main drivers are the ETF management costs, the index exposure that have an impact on transaction costs) or positive (in this case it means the manager is well skilled and it has implemented securities lending, for example, to generate performance within the fund).
On the other hand, tracking error is created as soon as the ETF does not replicate exactly over time what is going on in the index. This can also happen with intricate indices, such as with emerging markets, where it may not be easy or it might be costly to fully replicate the index.
Investors may choose to include ETFs in their portfolios to gain exposure to an index in a simple and relatively cost-efficient way. When looked at together, tracking error and tracking difference could help investors understand how well and, just as importantly, how consistently an ETF is tracking its index, and be able to compare ETFs based on the same indices.
Explore more of our ETF Fundamentals series online:
1 Diversification does not guarantee a profit or protect against a loss.2 In EU countries, both ongoing management costs (“Management fees and other administrative or operating costs”) and transaction costs are displayed in the Key Investor Document (KID). In the UK, only ongoing management costs (“Ongoing charges”) are published in the Key Investor Information Document (KIID). Transaction costs are not published in the legal documentation although they do impact the fund’s performance.3 Refer to footnote 2.
