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ETF Tracking Errors Rising

More ETF Concerns for Investors: ETF Tracking Errors on the Rise

As if investors didn’t already have enoughreasons to steer clear of exchange-traded funds (ETFs), new data show that the funds’ average tracking errors are on the rise.

A fund’s average tracking error is the difference between its return and its benchmark index’s return. Most ETFs (not includinginverse or leveraged ETFs) attempt to match as closely as possible the returns of their underlying benchmarks. This means that if a particular ETF tracked the S&P 500 and the S&P 500 gained 13.4% in 2012, then a well-managed S&P 500 ETF should theoretically render an investor a return of 13.4% minus the fund’s expense ratio. In practice, however, this isn’t always the case.

In fact, the average ETF’s tracking error for 2012 was 59 basis points, according to InvestmentNews. That reflects an increase from 2011, when the average tracking error was 52 basis points.

Two of the funds with the largest tracking errors in 2012 were iShares MSCI Emerging Markets Financials ETF (EMFN), with a tracking error of 5.3%, and Guggenheim S&P 500 Equal Weight Utilities ETF (RYU), with a tracking error of 4.4%.

Higher than average expense ratios will necessarily translate into higher than average tracking errors, but ETFs based on illiquid indices also tend to have greater tracking errors than ETFs based on bigger, more liquid indices. Investors who decide to invest in ETFs should make sure they fully understand the products’ risks, including a particular fund’s average historical tracking error. Additional risks to consider before investing can be found here.

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