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In theory, ETF's will track an underlying asset perfectly. In reality, there are often tracking errors that can negatively impact performance...
Exchange-traded funds (ETF's) are investment vehicles that aim to replicate the performance of a specific index, sector, or asset class. However, in reality, ETF's often deviate from their target benchmarks, resulting in a phenomenon known as tracking error.
What is tracking error?
Tracking error is the difference between the return of an ETF and the return of its underlying index or benchmark over a given period.
It can be positive or negative, depending on whether the ETF outperforms or underperforms its benchmark. Tracking error is an important measure of how well an ETF fulfils its objective of providing exposure to a certain market segment.
What causes tracking error?
There are multiple factors that can cause tracking errors in ETFs, such as
- Fees and expenses: ETFs charge management fees and other expenses that reduce their net asset value (NAV) and returns. These fees and expenses are not reflected in the benchmark index, creating a drag on the ETF's performance. The higher the fees and expenses, the higher the tracking error.
- Rebalancing and replication methods: ETFs may need to periodically rebalance their portfolios to match the changes in their target indexes. This involves buying and selling securities, which incur transaction costs and market impact.
- Moreover, some ETFs use sampling or synthetic methods to replicate their benchmarks, rather than holding all the securities in the index. These methods introduce tracking errors due to sampling error or counterparty risk.
- Dividends and distributions: equity ETFs receive dividends and interest payments from their holdings, which they distribute to their shareholders. However, these distributions may not coincide with the timing and amount of the dividends and interest payments in the benchmark index, creating a discrepancy in returns.
- Market conditions and liquidity: ETFs trade on exchanges like stocks, which means their prices are determined by supply and demand. However, their prices may not always reflect their NAVs, which are based on the value of their underlying holdings.
This creates a premium or discount in the ETF's price relative to its NAV, which affects its return and produces tracking errors.
Furthermore, some ETFs may face liquidity issues due to low trading volume or wide bid-ask spreads, making it difficult or costly to buy or sell them at fair prices.
In these circumstances, ETFs may try to use correlated but more liquid instruments to hedge their exposure they include stocks other than those in the benchmark or futures on an alternative index or sector - deviations in pricing and returns from these instruments can create a performance mismatch.
An example of tracking error in action
Some of the most notable examples of tracking error have happened in the US Oil Fund (USO) an ETF designed to track the returns of WTI crude oil and to do so by trading front-month crude oil futures.
However, in the Autumn of 2016, the performance of the fund diverged sharply from that of crude oil thanks to a contango in WTI futures.
Under a contango, the prices of front and near-month contracts fall in value because of a supply glut in the underlying market whilst far-dated contracts rise in value because they don't contain the additional expense of storing the underlying.
You may recall a similar situation in the spring of 2020 when oil storage facilities were full and front-month oil prices went negative as there was literally nowhere left to physically store oil.
Commodity-related ETFs and their close cousins ETNs are particularly sensitive to technical factors in their underlying markets' such as contangos and backwardations if they are trading deliverable contracts rather than cash-settled variants.
Some tracking error is inevitable for any ETF that tries to mimic a benchmark index. However, investors should be aware of the sources and magnitude of tracking errors for different Exchange Traded Products and funds, and choose those that have low tracking errors and high correlation with their target indexes.
Tracking errors can affect the risk-return profile and diversification benefits of an ETF portfolio, as such investors/ traders should monitor the degree of tracking error regularly and adjust their allocations accordingly if necessary.