The difference in performance between an ETF and its underlying index is known as “tracking error,” and it does vary, sometimes significantly, between different ETFs pegged to the same index. To understand tracking error, however, it’s important to first understand what an index actually is.
An index is simply a list of stock prices run through various mathematical formulas and used to track the performance of a particular sector of the market. The index itself holds no securities.
An index ETF, on the other hand, pays a fund manager to buy and sell the securities in its benchmark index. The management fees and transaction costs, along with administrative fees and other expenses, are reflected in the fund’s expense ratio, or percent of assets charged to shareholders to cover the costs of administering the fund. Expense ratios are the largest contributor to tracking error.
Here’s a look at the 2017 performance of four S&P 500 index funds; note that the index itself posted returns of 21.83% for the year.
|Fund name/symbol||Expense ratio||2017 returns|
|Schwab S&P 500 (SWPPX)||0.05%||21.79% (-0.04%)|
|Vanguard 500 (VFINX)||0.14%||21.67% (-0.15%)|
|Dreyfus S&P 500 (PEOPX)||0.50%||21.25% (-0.58%)|
|State Farm S&P 500 (SNPBX)||1.34%||19.82% (-2.01%)|
Other factors contributing to tracking error
Fund managers use different sampling methods to determine which securities on the index to hold in the fund. Keep in mind that some indices have hundreds or thousands of securities, some of which may be hard to find. Fund managers have discretion in determining which assets to hold as a representative sample of the index itself.
For example, the Russell 2000 is a small-cap index tracking the bottom 2,024 stocks in the Russell 3000. The Vanguard Russell 2000 ETF (VTWO) has 2,056 securities in its fund, while the SPDR Portfolio Small Cap ETF (SPSM), which also tracks the Russell 2000, holds just 2,007. These minor discrepancies in holdings also cause gaps in performance from the benchmark.
In addition to sampling methodology, fund managers use different methods to weight the securities as a proportion of the holdings. The most popular method by far is cap weighting, where the largest companies are more heavily weighted within the fund. Other methods favor different classes of equities. For example, the equal weighting method tilts toward small caps, while the dividend method tilts toward value stocks.
The RAFI weighting method is increasing in popularity because it considers four fundamentals (book value, sales, dividends, and cash flow) in assigning weights to the various equities in the fund. RAFI weighting tilts toward value stocks and companies with lower margins.
The fund manager’s skill in minimizing exposure to capital gains taxes and trading costs during portfolio rebalancing also have a slight impact on tracking error and overall returns.
For buy-and-hold long-term investors, tracking error and minor underperformance may not be as significant over time, since these investors typically look for low-cost ways to “own” an index. Short-term investors, on the other hand, should pay close attention to tracking differences between the fund and the benchmark.