If you have been investing for a long time in the share market, or more specifically in ETFs, then you have come across the terms tracking error and tracking difference. But if you are still using both terms, then you might react like, “Oh, these aren’t the same thing?”
Well, yes, tracking error and tracking difference are both different things.
If you are interested in an ETF, then knowing terminologies is extremely essential, in making these tracking techniques are needed to make decisions about the ETF, these tra. We will let you know, explain techniques and their difference, and explain. So, without any further ado, let’s get started.
What Is the Difference: Tracking Error vs Tracking Difference
When you are investing in the ETF, tracking differences will affect the result. It provides you with a better understanding of the performance between the ETF and the given benchmark over a certain period. To understand the tracking difference, there is a formula you can follow,
Tracking difference = ETF Return – Index Return
Let’s understand with an example,
Think that if the index return is 10% and your ETF return is 9.5%, then the tracking difference is going to be -0.5%. It can happen due to various reasons like cash drag, taxes, and fees. With the help of tracking differences, you can easily get a snapshot of how close the ETF can stay to the benchmark over a certain period.
What Is Tracking Error?
As we already said, tracking difference and tracking error are both different things, so this tracking error is going to measure the consistency of your ETF. To be more specific, it helps you to understand the consistency that matches the index from one period to the next. It can be used as a standard deviation of the return differences.
When your ETF underperforms by 0.4% every year, then it would be a low tracking error but a visible tracking difference. To get a high tracking error, your ETF sometimes should outperform and also sometimes should lag.
There is a basic formula for tracking error,
Tracking error = Standard Deviation of (ETF Return – Index Return).
When it comes to identifying the tracking error, always do a standard deviation first and then use the equation.
Why It Matters?
If you are an ETF investor, then the million-dollar question is which one you should care about, whether tracking difference or tracking error?
The answer will always be, depending on the different reasons.
- For Long-Term Planning: Tracking Differences
If you are a long-term investor and believe in a passive investment strategy, then tracking differences is something that matters for you. It lets you know how much you are collecting from the index’s return.
While calculating the tracking difference, you must know what a low tracking difference means.
- Low tracking differences mean efficient management.
- A minimal drag from holdings.
- Low fees.
While investing in an ETF, along with checking the expense ratio, always check the tracking difference as well, because a large gap can indicate the efficiency of your investment as well.
- For short-term planning: tracking error
When you trade an ETF frequently or if you are applying a hedging strategy or applying any other technical ways then tracking error is one of the essential tools for you.
Do you know what high tracking error means?
Well it means very less predictability. Over the short timing the ETF can diverge from the index in various unexpected ways. As a result it creates a messy condition with your trading thesis and also with your portfolio.
There is always a myth about low tracking error. People say a low tracking error means your ETF is performing better.
But remember you can have a low tracking error but it can also constantly leg the index. It means the ETF is under performing but in a very reliable way.
Causes Of Tracking Differences?
Many reasons can cause tracking differences, but among all, the most usual reasons are,
- ETF sometimes does not reinvest dividends immediately, therefore, it creates a performance lag.
- When you are holding an international ETFs, the foreign taxes can consume your returns.
- Expense ratio is one of the most obvious reasons because if you’re paying just 0.5% in fees, it will still add up over time.
- There are some ETF that hold a small cash reserve, this is why that does not earn as much as in the index.
Also, check – Difference between Mutual Funds vs. ETFs
Wrapping Up
Whenever investing in an ETF, always remember that the tracking difference and tracking error can have one of the most significant impacts on your holdings. In terms of getting as close as possible to the index performance and keeping the surprises minimum, investors prefer using this to metrics. So what are you still waiting for? Because whenever it is about an ETF, the devil is always hidden in the tracking details.
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Disclaimer – This article is for educational purposes only and does not intend to substitute expert guidance. Mutual fund investments are subject to market risks. Please read the scheme-related document carefully before investing.
