Investing in ETFs: Understanding tracking differences

Julie Brownlee, Fsp Invest, 31 Aug. 2015

Tags: tracking differences, etfs, investing in etfs, tracking differences in etfs, tracking errors,

Exchange traded funds (ETFs) can be a great way of benefitting from the performance of the market.

Depending on the ETF you invest in, you can track the performance of different indices on the Johannesburg Stock Exchange and stock markets worldwide, along with other assets.

But before investing in ETFs, you should be aware of tracking differences.

So what are tracking differences when it comes to ETFs?

Read on to find out…

What are tracking differences?

Ideally, an ETF should track the performance of its underlying index perfectly. For example, an ETF tracking the JSE Top 40 Index should replicate its performance exactly.

But in the real world, chances are there will be tracking differences or tracking errors. This means the ETF will either lag or beat the index by a margin.

Ideally, an ETF should track its underlying index very well. The measure of a good ETF is how well it tracks its underlying index.

The difference between tracking errors and tracking differences

These are two statistics that measure how good an ETF is at tracking its underlying index…

Tracking difference
This is the difference between the return of the index and the return of the ETF over a period of time.

For instance, if an index returns 15%, but the ETF returns 14%, there’s a tracking difference of -1%.

Tracking error
Tracking error is the standard deviation of the difference between the ETF’s returns and the index’s returns, explains the team of expert at Money Week. In other words, it measures how volatile an ETF’s tracking difference is.

For example, if an ETF has annual tracking differences of -1.3%, 0.5%, -1%, 0.15% and -0.5%, its tracking error would be 0.76%.

Checking for tracking differences when buying ETFs

It’s worth checking these tracking differences out when buying ETFs, especially when deciding among different ETFs that track the same index.

Most fact sheets for ETFs listed on the JSE include the tracking error. Just bear in mind that for young ETFs, there’s less data to base this on.

All fact sheets include the performance of the ETF in comparison to its underlying index too. And this gives you a good idea of how it weighs up to its index.

So there you have it. Understanding tracking differences when investing in ETFs.

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