What is the tracking difference of an ETF?
The tracking difference is the difference between the return of an ETF and the return of the index it follows over a given period, usually a calendar year:
It is usually negative: the fund returns a little less than its index, because the fund has costs and the index does not. It is the most complete measure of what an index fund really costs, because it captures everything that affects the investor's return, not only the fees that are listed.
What causes it
The tracking difference is the sum of several effects:
- The TER: the running costs, which lower the return every year.
- Trading inside the fund: the costs of buying and selling securities when the index changes or money flows in and out.
- Securities lending: many physical ETFs lend out shares for a fee, which improves the return.
- Taxes on dividends: a fund may pay more or less withholding tax than the index assumes; many benchmarks are net total return indices that deduct a standard rate.
- Sampling: funds that hold only a representative selection of the index's securities deviate a little from it.
These effects can partly cancel out. A fund with a TER of 0.20% can have a tracking difference of only −0.05%, or even a positive one, if securities lending and tax effects work in its favour.
A simple illustration
| ETF A | ETF B | |
|---|---|---|
| TER | 0.12% | 0.20% |
| Index return | 10.00% | 10.00% |
| ETF return | 9.80% | 9.95% |
| Tracking difference | −0.20% | −0.05% |
ETF A is cheaper on paper, but ETF B cost its investors less that year.
Tracking difference and tracking error
The two are easily confused:
- The tracking difference measures by how much the ETF's return fell short of, or exceeded, the index over a period — its cost.
- The tracking error measures how much the daily or monthly return differences fluctuate — its consistency. It is the standard deviation of those differences.
A good index fund has a small, stable tracking difference and a low tracking error.
How to use it
- Look at several years. One year can be distorted by special effects; the average over three to five years is more reliable.
- Compare funds on the same index. Differences between funds tracking different indices mostly reflect the indices, not the funds.
- Use it alongside the TER, not instead of it: the TER is known in advance, the tracking difference only afterwards.
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