Long-term quality of an ETF

Long-term quality of an ETF

Tracking Error
The ETF aims to track the index absolutely identically. Theoretically, the price of the ETF and the index should be absolutely identical. In practice, however, the price of the ETF and that of the index never coincide 100 per cent.
These fluctuations in the difference between the daily performance of the ETF and the daily performance of the underlying index are called tracking error. Tracking error does not necessarily mean that the ETF underperforms the underlying index. If the index is at 100 euros and the tracking error is 2%, the ETF can be at 102 euros or 98 euros. Tracking error is only about the deviation from the index price.
Even with a very small tracking error, the ETF price can deviate strongly from the index over the course of a year. This phenomenon is called tracking difference. More on this below.

How does the tracking error arise?

Through fees and time lags. The index has no management fees and no transaction costs. Moreover, the index assumes that distributed interest and dividends immediately appear in the fund’s account and are reinvested. The index is also not interested in the buying and selling costs incurred during conversions in the index.
In reality, transferring a dividend payment costs money and takes time. Sometimes taxes (UK equities are subject to Stamp Duty) or switching fees are also payable. Especially ETFs that invest in emerging market stocks are affected by this. The dividend of an Indonesian palm oil company must first be converted from rupiah to dollars and then travel from Indonesia to the fund company’s headquarters. There is no guarantee that all this will be done electronically. Shareholders may receive a cheque that they have to cash.

Too little money is held – during a downward phase it is not possible to get rid of one’s shares. Especially indexuniverse.eu is good for ETFs so check their Social Media:

What does the tracking error depend on?

On the one hand, on the expertise of the fund company. But all the big providers have that. Essentially, the tracking error depends on the type of index replication.
Replicators hold the shares and are therefore closer to the „real“ world. Therefore, they have to deal with a higher tracking error. Large indices, such as the MSCI World with around 1,800 positions, cannot be replicated without tracking error.
Synthetic swappers have an easier time of it. They are purely electronic. No constraints of the carbon world interfere with them. That is why the tracking error is much lower here, but of course it exists, because the management does not waive its fees here either.

Tracking difference

The tracking difference measures the long-term quality of an ETF. This indicator answers the question: How well is the ETF expected to perform compared to the corresponding index? While tracking error is a relative metric, tracking difference measures the difference in performance in absolute terms – did the ETF outperform the index or lag behind?
The standard period for the tracking difference is 1 year. Tracking differences can only be determined retrospectively.
The tracking difference includes all fund-level items such as fees, brokerage commissions, taxes, securities lending gains that affect the fund’s return. Since these positions generally do not change that quickly, the tracking difference is nevertheless a very valuable variable when it comes to estimating the future performance of an ETFS.
This gives investors the chance to get an idea of the actual ETF costs and the resulting performance. The costs are directly charged to the ETF performance.

Securities lending
The fund management earns extra money with securities lending. In this case, the fund’s securities are lent out for a fee. The borrower must deposit collateral so that the fund does not suffer any financial loss in the event of insolvency.
The problem with this is that the management places the counterparty risk on the fund buyer, i.e. you (the borrower becomes insolvent), but in most cases collects the lending fees. More details are in the fine print. Search for „securities lending“ in the PDF. ETF issuers are required to address this issue in investor documents, but for understandable reasons do not make a big deal about it.
Virtually every fund engages in securities lending. Pick a fund where you at least benefit from the lending fees. Then you at least get paid for the additional risk and can further minimise the tracking error.