Why you should pay attention to tracking error when investing in ETFs

Julie Brownlee, Fsp Invest, 30 Nov. 2015

Tags: etfs, investing in etfs, tracking difference, tracking error,

Exchange traded funds (ETFs) are a great way to invest in the stock market. With just one purchase, you have exposure to a basket of shares.

They’re easy to buy and sell, and the number available to invest in continues to grow.

As much as ETFs have a number of benefits, there are also things you need to watch out for. This includes tracking error.

So what is tracking error? And why should you care about tracking error?

Let’s take a closer look…

What is tracking error?

With tracker funds, such as ETFs, ideally the performance of the ETF should mirror the performance of its benchmark index perfectly. For example, an ETF on the JSE Top 40 Index should mirror the performance of the JSE Top 40 Index.

But in reality this isn’t the case. There is always a ‘tracking error’. The ETF either lags the performance of the index or it beats the performance of the index.

A sign of a good ETF is one that tracks its benchmark as closely as possible.

What is tracking difference?

There will always be some ‘tracking difference’. This is the difference between the ETF’s return and the index’s return.

For example, if an ETF returns 10% and the index returns 11%, that’s a tracking difference of -1%.

The tracking error comes from the standard deviation of the difference between the ETF’s returns and the returns on the index.

In other words, it measures how volatile an ETF’s tracking difference is on an annual basis.

For both tracking error and tracking difference, the lower the number, the better an ETF is at doing its job.

You’ll find this information on an ETF’s fact sheet.

So there you have it. Why you should pay attention to tracking error when investing in ETFs.

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