Tracking Error Explained

Tracking error happens when a fund's performance deviates from the performance of an index it seeks to track.

The SPY ETF is supposed to track the performance, before fees and expenses, of the S&P500 index. Should the fund perform above or below the performance of the S&P500 index, it would experience tracking error. It would fail to track perfectly the changes in the index.

How Tracking Error Works

Tracking error commonly results from active portfolio management. A fund company may seek to provide returns equal to an index without mimicking the index perfectly.

Exchange-traded funds are known to make investments that are different from the given name of the fund. Whereas a stock fund seeking to replicate the S&P500 index should own all 500 companies in the index, it might substitute S&P500 futures as a derivative. S&P500 futures do not always perfectly track the value of the stocks in the index, which means the fund's performance will naturally differ from the S&P500 index itself.

Tracking error also occurs when the value of the fund differs from the value of the assets held in the fund. Each fund has its own Net Asset Value, or NAV. The NAV tells us what the holdings of the fund are worth per share of the fund.

There are two different types of tracking error directly related to fund pricing in the open market:

1. Premium – When a fund sells for more than the net asset value, it is said to sell at a premium.
2. Discount – When a fund sells for less than the net asset value, it is said to sell at a discount.

Why Tracking Errors Hurt Investors

Exchange-traded funds and closed-end funds are designed to allow investors exposure to different parts of the financial market without a lot of difficulty. Exposure to a particular part of a market only becomes beneficial when the fund tracks accurately the performance of a segment it is designed to track. That is to say, a normal ETF should not rise in value when the index falls, or fall in value when the index rises.

ETFs are supposed to track an index perfectly. In reality, all funds have some tracking error – usually less than a few hundredths of a percentage point at any one time – but some have very large tracking errors. Some funds are so thinly-traded that the fund may trade at a premium or discount for a very long time.

ETFs with Tracking Errors

1. Sprott Physical Silver Trust (PSLV) – A low-volume, closed-end fund, Sprott Physical Silver Trust poorly tracks the value of physical silver. In fact, investors would have enjoyed outperformance of 8% over silver prices in a one-year period, while another PSLV investor would have underperformed silver prices by more than 20% in a ten-month period.  Also watch for market inefficiencies like I've highlighted previously where you can exploit the pairs trade when premiums get out of whack.
2. iShares MSCI Emerging Market Index Fund (EEM) – This fund is an international fund, and thus it experiences tracking error in the overnight periods when foreign markets are open and US markets are closed. However, the fund has, at times, diverged both positively and negatively from the performance of the underlying index by as much as 10% in either direction. A competing fund by Vanguard, which tracks the very same index EEM purports to track, VWO, has tracked the index perfectly.
3. iShares FTSE NAREIT Mortgage REIT Index (REM) – REM tracked horrendously its underlying index due to diversification requirements. The fund is supposed to track the FTSE NAREIT Mortgage Index, but diversification rules would not allow for the fund to hold some REITs in the same proportion as the index. The Index, at one time, invested more than 50% of its NAV into a single REIT. iShares is limited by law to limit single holdings to less than 25% of an ETF.
4. US Natural Gas Fund (UNG) – The fund tracked horribly the change in natural gas prices, losing more than 85% of its value in a 3-year period in which natural gas prices fell only 50%. All futures-based commodity funds show similar tracking error in the long-haul due to contango.

Some Tracking Error is Unavoidable

Some tracking errors are unavoidable. An ETF on a US-based exchange tracking a European index will almost always have some tracking error, especially when the US-based exchange is closed and the European exchanges are open. By the time the US markets open, however, prices should adjust in the US to reflect changes in the value of the index in Europe.

This kind of tracking error is temporary, expected, and frankly, not worth worrying about. However, if the fund consistently sells for a price well below or well above its net asset value, investors do have cause for concern. It is possible for investors to pay a premium to buy an exchange-traded fund, only to later sell the fund at a discount to net asset value.

One might purchase ETF shares for $22 when the NAV is $20. After a bull market, the NAV rises to $25 and the fund moves to $24. In effect, investors lose $3 due to tracking error – paying too much for the fund at one point and selling it for too little at another point. What should have been a $5 gain per share is a mere $2 gain, or a 25% return vs. 10%.

How to avoid tracking error

Below you will find a few ways you can filter out funds to eliminate tracking error in your portfolio:

1. Look for volume – A fund should trade at least 1,000,000 shares per day to avoid tracking error. High-volume funds are targets for arbitragers, people who make money by arbitraging the difference between an index and an ETF. If GLD were to trade 5% higher than gold bullion spot pricing, arbitragers could sell short the GLD ETF and buy gold futures to essentially profit when the tracking error is corrected. (See how to short gold and also remember that GLD is taxed at a much higher rate due to gold collectibles tax rates over capital gains.).
2. Buy open-ended funds – Exchange-traded funds are open-ended. At any one time, an investor can purchase large blocks of S&P500 stocks and exchange these shares for shares in the SPY ETF. This allows arbitragers to trade shares of S&P500 components for SPY shares when the ETF trades for a premium. When the SPY sells at a discount, arbitragers can request delivery of shares backing the fund in exchange for shares in S&P500 components. Closed-end funds do not allow for this operation; new shares in the fund cannot be created by request, nor can shares be redeemed upon request. Investors can only exit a closed-end fund by selling their shares in the fund in the open market, which may have a price very different from the net asset value.
3. Consider ETNs – Exchange-traded notes are simple by design. An exchange-traded note is a promise by the issuer sold on the open market. At any one time, institutional investors can request the issuer allow a cash-out from the ETN, or purchase new notes to create new ETN shares. The proximity to cash makes high-volume ETNs some of the best tracking funds out there, as it is a simple cash transaction to create and redeem ETN shares.
4. Due diligence – It takes all of a few minutes to do some research to compare the returns of an ETF vs. the returns of the index an ETF reportedly seeks to mimic. A simple chart of one ETF vs. the index over a period of one year or more will provide a very good understanding of how well an ETF tracks its index.

Tracking error is a very real problem with indexing, a flaw proponents aren't quick to identify for new investors. One can avoid most of the difficulty, however, with a few minutes of analysis – analysis that could save investors hundreds of thousands of dollars over the long haul.

Disclosure: No positions in any ETFs or ETNs covered here.

Written by JT, who blogs about money and finance at MoneyMamba.com

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