Tracking difference is a very helpful metric which can help you figure out whether your ETF is doing its job or not.
Most ETFs track an index such as the FTSE 100. So for a FTSE 100 ETF, the ETF is aiming to replicate the performance of the FTSE 100 as closely as possible. If the FTSE 100 rises ten per cent over a year, then the ETF wants to get as close as possible to a 10% rise.
If the FTSE 100 rises 10% over a year, and the FTSE 100 ETF only rises by 9%, then the tracking difference is 1%. To put it another way, tracking difference is the discrepancy between ETF performance and index performance. Tracking difference is rarely zero, the ETF normally lags the index a little.
Tracking error is different. It’s about variability rather than performance. It basically looks at the volatility in the difference of performance between the fund and its index. If an ETF has low tracking error, you might feel more confident that it will at least continue with roughly the same tracking difference it’s delivered in recent history.
So which factors affect tracking difference?
The ETF’s annual charges are inevitably a factor in any ETF’s tracking difference. If an ETF has a Total Expense Ratio (TER) of 0.5%, then you might expect the tracking difference to be 0.5% too.
However other issues also come into play.
When an index rebalances, typically every 3 months, the weightings of the companies in the index are changed. Also, companies sometimes exit the index and new ones come in.
The ETF has to trade stocks to reflect those changes, and the trading incurs trading costs.
Some ETFs don’t own shares in all the companies in an index. If the index contains 800 different companies, it’s easier to invest in a representative sample of the whole index. Bond ETFs are particularly likely to use sampling as bond indices can contain thousands of different bonds, many of which are illiquid.
Sampling is a good idea in many ways, but it may lead to some tracking difference.
Some ETFs receive regular dividends from the assets in their portfolios. ETFs often hang onto the cash for a few months before distributing it to shareholders. These slugs of cash can also lead to tracking difference.
When an index rebalances or reconstitutes its components, the changes are instantaneous. In contrast, an ETF tracking the index must go out and transact in order to realign itself with the index. During the time it takes to buy and sell the necessary securities, prices move and create tracking difference between the index and the ETF.
Some ETFs lend some of the assets in their portfolios to borrowers, most likely short-sellers. This creates extra income for the ETF, but that extra income can also lead to further tracking difference.
If you want to find out the tracking difference and tracking error for a particular ETF, check out the Trackinsight website.