Although rarely considered by the average investor, tracking errors can have an unexpected material effect on an investor's returns. It is important to investigate this aspect of any ETF index fund before investing.

The goal of an ETF index fund is to track a specific market index, often referred to as the fund's target index. The difference between the returns of the index fund and the target index is known as a fund's tracking error.

Most of the time, the tracking error of an index fund is small, perhaps only a few tenths of one percent. However, a variety of factors can sometimes conspire to open a gap of several percentage points between the index fund and its target index. In order to avoid such an unwelcome surprise, index investors should understand how these gaps may develop.

SEE: Investopedia Special Feature: Exchange Traded Funds

What Causes Tracking Errors?
Running an ETF index fund might seem like a simple job, but it can actually be quite difficult. ETF index fund managers often employ complex strategies in order to track their target index in real time, with fewer costs and greater accuracy than their competitors.

Many market indexes are market capitalization weighted. This means that the amount of each security held in the index fluctuates, according to the ratio of its market capitalization against the total market capitalization of all securities in the index. Since market capitalization is market price times shares outstanding, fluctuations in the price of securities causes the composition of these indexes to change constantly.

An index fund must execute trades in such a way as to hold hundreds or thousands of securities precisely in proportion to their weighting in the constantly changing target index. In theory, whenever an investor buys or sells the ETF index fund, trades for all of these different securities must be executed simultaneously at the current price. This is not the reality. Although these trades are automated, the fund's buy and sell transactions may be large enough to slightly change the prices of the securities it is trading. In addition, trades are often executed with slightly different timing, depending on the speed of the exchange and the trading volume in each security.

SEE: Sharpen Your Portfolio With Intelligent ETFs

Diversification Rules
Securities regulations in the U.S. require that ETFs may not hold more than 25% of their portfolio in one stock. This rule creates a problem for specialized funds seeking to replicate the returns of particular industries or sectors. Truly replicating some industry indexes can require holding more than 25% of the fund in certain stocks. In this case, the fund cannot legally replicate the actual index in full, so a tracking error is very likely to occur.

Fund Management and Trading Fees
Fund management and trading fees are often cited as the largest contributor to tracking error. It is easy to see that even if a given fund tracks the index perfectly, it will still underperform that index by the amount of fees that are deducted from a fund's returns. Similarly, the more a fund trades securities in the market, the more trading fees it will accumulate, reducing returns.

Securities Lending
Securities lending occurs primarily so that other market participants can take a short position in a stock. In order to sell the stock short, one must first borrow it from someone else. Usually, stocks are borrowed from large institutional fund managers, such as those that run ETF index funds. Managers who participate in securities lending can generate additional returns for investors by charging interest on borrowed stock. The lending fund still maintains its ownership rights to the stock, including dividends. However, the fees generated create additional return for investors above what the index would realize.

What Tracking Error Means for the Individual Investor
Often, the advice given is to simply buy the index fund with the lowest fees, but this may not always be advantageous if the fund does not track its index as well as expected.

The key is for investors to understand what they are buying. Make sure that the ETF index fund you are considering does a good job of tracking its index. Key metrics to look for here are the fund's R-squared and beta. R-squared is a statistical measure that indicates how well the index fund's price movements correlate with index. The closer the R-squared is to one, the closer the index fund's ups and downs match those of the target index.

SEE: Regression Basics For Business Analysis

You will also want to ensure that the fund's beta is very close to the target index's beta. This means that the fund has about the same risk profile as the index. Theoretically, a fund can have a close correlation with its index, but still fluctuate by a greater or lesser margin than the index, which will be indicated by a different beta. These two metrics together indicate that the fund will track the index very closely. Finally, a visual inspection of the fund's returns versus its benchmark index is a good sanity check on the statistics. Be sure to look at different periods to make sure the index fund tracks the index well over both short-term fluctuations and long-term trends.

The Bottom Line
By doing the simple homework suggested above, you can make sure that an ETF index fund tracks its target index as advertised, and you will stand a good chance of avoiding a tracking error that might adversely affect your returns in the future.

SEE: ETFs Vs Index Funds: Quantifying The Differences

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