How do you know if an ETF is doing its job well?
Some might turn to last year's performance, but performance isn't the answer—markets go up and down regardless of how well an ETF does its job.
The simplest answer is "tracking difference." Tracking difference is the investors' metric for assessing whether they're getting what they pay for. As such, it's one of the most important ETF statistics to consider.
What is tracking difference?
The vast majority of ETFs aim to track an index—which means that ETFs try to deliver the same returns as a particular index. Tracking difference is the discrepancy between ETF performance and index performance.
Tracking difference is rarely nil: The ETF usually trails its index. That's because a number of factors prevent the ETF from perfectly mimicking its index. ETF returns don't always trail their index though; tracking difference can be small or large, positive or negative.
Tracking error is a related but distinct metric. Tracking error is about variability rather than performance. Math geeks measure variability through standard deviation. Tracking error is the annualized standard deviation of daily return differences between the total return performance of the fund and the total return performance of its underlying index.
In laymen's terms, tracking error basically looks at the volatility in the difference of performance between the fund and its index.
So, what factors affect how well a fund tracks its index?
Total expense ratio
An ETF's total expense ratio (TER) is the single best indicator of future tracking difference. If an ETF charges 1% to track an index, then all else equal, ETF returns ought to lag index returns by exactly 1%. That's why TER is so important, and ETF issuers are constantly competing to offer the lowest fee.
While TER is the best indicator of future tracking difference, all else isn't equal—other factors come into play.
Transaction and rebalancing costs
When an index rebalances its constituents, adds a new company or removes a company, the ETFs tracking the index must adjust their holdings to reflect the current state of the index. As such, the ETF must buy and sell its underlying securities and incur the associated trading costs. Those costs must be paid with the fund's assets which, consequently, increases tracking difference.
ETFs that track indexes with many securities, illiquid securities, or that rebalance frequently by design (like an equal-weighted index) will incur greater transaction and rebalancing costs, which will increase tracking difference.
Sometimes it's impractical or infeasible to hold every company in an index. Some indexes (especially bond indexes) have thousands of securities in them—some of which may be difficult to acquire at a fair price. Rather than incur the transaction and rebalancing costs associated with buying and selling every security within their index, some ETFs opt to hold a representative sample.
In indexes with thousands of securities, the smallest securities have tiny weights and negligible impact on performance. To save on costs, ETF managers may choose to skip out on some of those small securities to save on costs.
Some ETFs receive dividend distributions from their underlying securities and distribute them to ETF shareholders. However, ETFs don't distribute these dividends on a real-time basis (like the paper portfolios maintained by index providers assume), they do so periodically.
The ETF will have "cash drag" during the period between when the ETF receives a dividend and when it distributes those dividends to shareholders. Investment managers can choose to temporarily reinvest those dividends, but those reinvestments also have costs. Holding part of its portfolio in cash, or engaging in reinvestment transactions, the ETF will have slightly different returns than the fully invested index—causing tracking difference.
When an index rebalances or reconstitutes its components, the changes are instantaneous. In contrast, an ETF tracking the index must go out and transact in order to realign itself with the index. During the time it takes to buy and sell the necessary securities, prices move and create tracking difference between the index and the ETF.
Some ETFs lend the securities in their portfolio to paying borrowers (often short-sellers). This creates additional revenue for the ETF above and beyond what is covered in the index. In short, securities-lending revenue can help reduce the costs of the ETF and improve its tracking difference.
The amount of revenue generated from securities lending depends on prevailing capital-market lending rates for those particular securities. Heavily shorted securities typically command higher premiums and could generate significant securities-lending revenue, while others may be relatively insignificant.
In the end, many behind-the-scenes factors affect how well an ETF reflects the returns of its underlying index. As investors, tracking difference is our best tool for assessing how all these factors interact and, ultimately, how well the ETF delivers on its promise. Look for low—or even positive—tracking differences that are relatively stable over time.