What is ETF Tracking Error? : NobleTrading Blog

ETF tracking error is the divergence of an exchange traded fund's return from the benchmark return. This can be positive (ETF outperformance) or negative (ETF underperformance). As there is asset management costs involved, all ETFs tend to have tracking errors which is usually lower than that of mutual funds but some ETFs can have high tracking errors equaling or exceeding mutual funds.

ETF tracking errors are expressed as standard deviation from the index it is tracking. ETFs tracking broad indexes tend to have low tracking errors compared to those tracking specific sectors/indexes/foreign markets. ETF tracking errors should always be interpreted with respect to the return. For example a tracking error of 0.5% can be considered low when the return is ETF 10% but very high when the return is only 2%. Below are some main reasons for high tracking errors.

High management expense ratios: leverage ETFs, smart ETFs, etc tend to beat the market with active management of ETF portfolio. This active management involves costs and results in tracking errors.
Portfolio optimization: many times it is not possible with existing fund features to buy all stock/securities of the index; eg: some thinly traded stocks. So ETFs use samples, which can result in tracking errors.
Securities lending fees: some ETFs lend equities to hedge funds for short-selling. The lending fees collected from these hedge funds can alter the total ETF return.
Diversification constraints: sector ETFs tracking specific sectors can find it difficult to replicate the sectors, because there will be some dominant companies which makes up to half of that sector. ETFs are usually not allowed to invest more than 25% of their asset in a single stock.
ETFs may require cash holdings to buy and sell securities, which can result in tracking errors.
Commodity ETFs which roll futures can have high tracking errors because of contango and backwardation.
Capital gain distributions and hedging risks can also result in ETF tracking errors.