The Importance of Tracking Error in ETFs

16 June 2025

Exchange-Traded Funds (ETFs) have revolutionized investing with their low costs, diversification, and liquidity. But if you’ve ever invested in an ETF, you might have noticed something interesting—it doesn’t always perform exactly like the index it’s supposed to track. Why is that? The answer lies in something called tracking error.

Tracking error is a crucial metric for investors who rely on ETFs to mirror the performance of a benchmark index. But what exactly is it, and why does it matter? Let’s dive in and break it down in simple terms.

What Is Tracking Error?

At its core, tracking error measures the difference between an ETF’s performance and the performance of its benchmark index. Ideally, an ETF should move in lockstep with its benchmark, but in reality, that’s rarely the case.

It’s calculated using the standard deviation of the difference between the ETF’s returns and the index’s returns over a given period. A high tracking error means the ETF deviates significantly from the index, whereas a low tracking error indicates it closely follows the benchmark.

Formula for Tracking Error

If you love numbers, here’s a simplified version of the formula:

\[
Tracking\ Error = \sqrt{\frac{\sum (ETF\ Return - Index\ Return)^2}{n}}
\]

Where:
- ETF Return is the return of the ETF over a specific period
- Index Return is the return of the benchmark index
- n is the number of observations

But don’t worry—if formulas make your head spin, the key takeaway is this: tracking error tells you how much the ETF is straying from where it should be.

Why Does Tracking Error Happen?

There are several reasons why an ETF might not perfectly track its index. Let’s break down the most common causes.

1. Expense Ratios

Every ETF has an expense ratio, which represents the annual fees charged to investors. Even if these fees seem small—say, 0.10%—they can add up over time and affect performance. Since an index doesn’t have expenses (it’s just a theoretical calculation), the ETF will always lag slightly behind due to costs.

2. Cash Drag

Ever notice how some ETF distributions don’t get reinvested immediately? This is known as cash drag. If an ETF receives dividends from its holdings but doesn’t reinvest them right away, that cash sitting idle can cause it to underperform the index.

3. Replication Strategy

Not all ETFs fully replicate their benchmark. Some use sampling, meaning they hold only a subset of the index’s securities rather than every single stock or bond. This can create deviations from the index—especially in indices with thousands of securities, like the Bloomberg U.S. Aggregate Bond Index.

4. Rebalancing Discrepancies

Indices change over time. Companies get added, others get removed, and weightings shift. ETFs must adjust their holdings to reflect these changes, but they don’t always do it instantaneously. Any delay in rebalancing can cause performance differences.

5. Liquidity and Market Impact

Some ETFs invest in highly liquid stocks, while others hold thinly traded assets. For ETFs tracking international markets or niche sectors, buying and selling securities can be tricky—and expensive—leading to performance deviations.

6. Currency Fluctuations

If you invest in an ETF that tracks an international index, currency fluctuations can introduce another layer of tracking error. The ETF might hedge against currency risk, but even that can affect how closely it follows the benchmark.

Why Should Investors Care About Tracking Error?

You might be wondering, why does this even matter? After all, ETFs are mostly tracking their indices, right?

Well, if you’re using ETFs to build a diversified, passive portfolio, you want them to do their job as efficiently as possible. A high tracking error means an ETF isn’t doing what it’s supposed to—matching the performance of the index.

1. A Low Tracking Error Means Better Index Replication

If your goal is to mimic an index’s performance, you want an ETF with a low tracking error. If it’s consistently missing the mark, you might not get the investment results you were expecting.

2. High Tracking Error Can Mean Higher Risk

A high tracking error suggests that an ETF is behaving unpredictably. If it’s deviating significantly from the index, you might be unintentionally taking on more risk than you bargained for.

3. Consistency Matters for Long-Term Investors

If you’re a long-term investor, small deviations may not seem like a big deal now. But over decades, consistent underperformance due to tracking error can add up, potentially costing you thousands of dollars in lost returns.

How to Use Tracking Error When Picking an ETF

Now that you understand what tracking error is, the next logical step is learning how to apply it when picking investments. Here are a few pointers:

1. Compare Tracking Errors Across Similar ETFs

If you’re deciding between two ETFs that track the same index, check their tracking errors. The one with the lowest tracking error is likely a better choice because it closely follows the benchmark.

2. Look at the Historical Tracking Error

A one-time deviation might not be alarming, but a long history of high tracking error is a red flag. Review an ETF’s past performance relative to its index to gauge consistency.

3. Consider Expense Ratios

Since expense ratios contribute to tracking error, choose ETFs with lower fees whenever possible. Over time, lower costs can help minimize performance discrepancies.

4. Avoid Synthetic ETFs If You Want Low Tracking Error

Some ETFs use derivatives instead of holding actual stocks or bonds. These are known as synthetic ETFs, and they tend to have higher tracking errors. If precise index tracking is a priority, opt for physical ETFs that fully replicate the index.

5. Check for Tracking Difference

While tracking error measures variability, tracking difference tells you how much the ETF’s total return differs from the index. Both are useful metrics when evaluating ETF performance.

Final Thoughts

Tracking error might not be the first thing that comes to mind when picking an ETF, but it’s an essential factor in making smart investment decisions. The goal of an ETF is to replicate an index—not to surprise you with deviations.

Before you invest, take a few minutes to review the tracking error of your chosen ETF. It might seem like a small detail, but over the long run, it can make a significant impact on your portfolio’s returns.

So, next time you’re evaluating ETFs, don’t just look at expense ratios and past performance—check the tracking error, too. It’s a small step that can make a big difference in the quality of your investment choices.