ETFs and mutual funds share similar methods of performance measurement. Like mutual funds, ETF prices are determined by the value of the underlying securities in the fund. This value rises and falls with the value of the underlying investments. NAV only tells part of the performance story, as dividends and capital gains must also be taken into consideration when calculating the total return on the investment.

Tracking Errors
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.

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 can cause 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.

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.

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.

Related Reading:



Which Is Better?

Related Articles
  1. ETFs & Mutual Funds

    ETF Tracking Errors: Protect Your Returns

    Tracking errors tend to be small, but they can still adversely affect your returns. Learn how to protect against them.
  2. ETFs & Mutual Funds

    ETFs Can Be Safe Investments, If Used Correctly

    Learn about how ETFs can be a safe investment option if you know which funds to choose, including the basics of both indexed and leveraged ETFs.
  3. Managing Wealth

    3 Index Funds with the Lowest Expense Ratios

    Read detailed information about index mutual funds with some of the lowest expense ratios in their categories, and learn about their pros and cons.
  4. ETFs & Mutual Funds

    The Hidden Differences Between Index Funds

    These funds don't all match index returns. Find out how to avoid costly surprises.
  5. ETFs & Mutual Funds

    Enhanced Index Funds: Can They Deliver Low-Risk Returns?

    These funds may look appealing. Find out whether they can really live up to all of their promises.
  6. ETFs & Mutual Funds

    Exchange-Traded Funds: Index Funds Vs. ETFs

    In much of the previous discussion comparing mutual funds to ETFs, the merits of actively managed mutual funds are compared to the passively managed ETFs. In some ways, it is like comparing apple ...
  7. ETFs & Mutual Funds

    The 4 Best U.S. Equity Index Mutual Funds

    Find out which four index mutual funds are among the best U.S. equities index mutual funds for core holdings in your investment portfolio.
  8. ETFs & Mutual Funds

    ETFs Vs Index Funds: Quantifying The Differences

    When it comes to the ability to track the performance of an index, exchange-traded funds and index funds each have certain advantages.
  9. ETFs & Mutual Funds

    ETFs Vs. Index Funds: Quantifying The Differences

    If you are trying to choose between these two index-tracking investments, compare the costs.
  10. ETFs & Mutual Funds

    Dissecting Leveraged ETF Returns

    These funds are a relatively new product to most investors, but they could be what you need for increased returns.
Trading Center