What affects index tracking?

 

Excess return (sometimes referred to as tracking difference) and tracking error are important metrics to consider when evaluating ETFs. Understanding what they measure can help you make smarter investment decisions for your clients. Expand the sections below to learn how these investment measures work.

Excess return | more

Excess return measures an ETF's performance against its benchmark index over a specific period of time.

Calculating excess return is rather simple: Subtract the index's total return from the ETF's total return.

Excess return can be positive or negative and reveals the extent to which an ETF outperforms or underperforms its benchmark index. Remember, since an ETF's performance includes its expenses, excess return is typically negative for ETFs.

Factors affecting excess return

Factors affecting excess return

Tracking error | more

ETF providers define tracking error in different ways. Some simply refer to it as the difference between an ETF's return and the return of its benchmark index, which is really excess return. However, the formal definition of tracking error is the annualized standard deviation of excess return. In other words, while excess return measures the amount by which an ETF's return differs from that of its benchmark over a specified period, tracking error measures how much variability exists in the ETF's excess return.

For example, if the tracking error is 50 basis points, about two-thirds of the time the ETF's excess returns are expected to be within 50 basis points of the average excess return. A lower tracking error would suggest lower variability of the excess return.

We believe that if your primary objective is seeking total return for your clients over a long-term time horizon, then excess return is a more important measure than tracking error. However, over the short term, you may care more about performance consistency and want to minimize volatility, in which case you should focus on tracking error.

 

Key causes of tracking error and negative excess return

In an ideal world, ETFs would perfectly track their benchmark indexes and negative excess returns and tracking error would not exist. However, from a practical standpoint, a number of factors work to make that ideal impossible to achieve.

Expenses

Higher expenses can lead to lower returns by creating a drag on performance. Expenses can come in various forms such as expense ratios or portfolio trading costs as a result of market characteristics and the liquidity of an ETF’s underlying securities.

Degree of index replication

Higher degrees of index replication typically lead to lower tracking error. At times it can be impractical to hold every security in an index. Rather than incur the transaction costs associated with full replication of a target index, an ETF can choose instead to hold a representative sample of the securities in an index, which can lead to tracking error.

Fair-value pricing

Fair-value pricing can be an influential driver of tracking error. Fair-value pricing is a strategy used to align the prices of the underlying securities with their true value.

Some ETFs will use fair-value pricing if the value of their underlying securities is affected by events occurring before the U.S. market closes but after the close of markets or exchanges on which the securities are traded. This situation most commonly occurs with foreign securities, which may trade on foreign exchanges that close many hours before the ETF is priced in the United States. Fair-value pricing addresses the price discrepancies in such a scenario. As a result, tracking error for a fair-value-priced ETF versus its target index may be temporarily observed.

Fair-value pricing can discourage short-term trading: short-term trading can drive up costs and, potentially, taxes for ETF shareholders. The interactive example below shows how Vanguard prices its ETFs using fair-value methodology.


         

Securities lending

Securities lending is a common practice among mutual funds, ETFs, pension funds, and insurance companies, which lend securities from their portfolios to broker-dealers, hedge funds, and investment banks in return for a fee. Collateral, generally in the form of cash and/or government securities, is delivered by the borrower in an amount greater than the loaned securities' value. In addition to the fee that a lender can generate from lending a security, the lender also earns interest by reinvesting the cash collateral.

Securities lending can benefit investors by offsetting some of the ETF's expenses, resulting in better performance.

Vanguard's unique approach to securities lending

While Vanguard engages in securities lending in several of our funds, our program is differentiated by Vanguard's client-owned structure, which drives our approach to conduct business in the best interests of our clients. (As a client-owner, you own the funds that own Vanguard.) That means taking a very conservative approach to risk, minimizing program costs, and returning all securities-lending revenues, net of costs, to fund shareholders. Other fund providers may keep a large portion of revenue to cover costs and retain a profit.

We encourage you to read this informative piece on securities lending.

All investing is subject to risk, including possible loss of principal.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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Related materials

Fair-value pricing

Client approved

Understanding excess return and tracking error  

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