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What causes an ETF tracking error?



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Hello Kelvin,
A tracking error checks the difference between the actual performance of a fund and that of the index. The difference in the returns most times varies mostly due to differences in the management fees. 
One other reason why an ETFs returns may be different from that of its index is currency hedging. When a currency is at risk, the ones controlling it may obstruct it using a futures contract. If there is a massive change in the currency movement during the contract, this can show as a tracking error.
Keeping additional cash available so that you can pay stockholders who repossess their units may also result in tracking error.
A poor sampling of the stocks which need to be held in the funds may also lead to substantial tracking errors. Such may occur when, for example, you decide to hold just a fraction of the stocks in the Exchange-traded funds.
Securities lending may also result in tracking errors. Several index funds lend securities such as stocks so that they can get an additional income. It is usually not a bad idea; however, the index funds need to ensure that the tracking error is less than the management fee.

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