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We know that most ETFs are designed to track a particular asset (gold, silver, etc.) or basket of assets (equity and bond indexes). But ETFs can’t exactly replicate the performance of their benchmark due to various factors (we will discuss this in the article).
So, to measure the deviation of the returns from the benchmark, we use tracking error and tracking difference. Let’s understand them in more detail.
Tracking error is the measure of divergence of performance of a portfolio (ETF in our case) with respect to a particular benchmark. Tracking error can be applied to any portfolio. For ETFs that track a particular benchmark, minimizing tracking error is a primary objective.
Remember, ETFs (passive ones) are set up to track the performance of a benchmark. Therefore, tracking error gives a sense of how “good” (or bad) the ETF has been in tracking the benchmark’s performance. Low tracking error is always desired.
Mathematically, tracking error is measured as the standard deviation of the difference in return between the ETF and the benchmark. In general, tracking error is calculated as follows:
It is important to note that the SEBI has demanded AMCs to calculate and report tracking error as per the following formula: Annualized standard deviation of the difference in daily returns (of the last 1 year) between the benchmark and the NAV of the ETF.
Now that we have a solid idea about what tracking error is, let’s understand the reasons that cause tracking error.
In an ideal world, ETF performance should be exactly the same as the benchmark. But that doesn’t happen and hence we have the tracking error.
There are multiple reasons for tracking error. The prominent factors are:
Investors should not use tracking error as the sole metric to choose ETFs. At the end of the day, investors are concerned with the final return rather than the variability of the return. An ETF return will always lag the index it tracks (factors discussed above). Tracking error may not completely capture the magnitude of this lag.
Another problem with tracking error is the way it is reported. AMCs report tracking error based on NAV. A retail investor, trading on an exchange, deals with prices rather than NAV.
As we have already seen, ETFs can trade at a discount/premium to NAV. This is more frequent for ETFs with low liquidity. However, during times of severe market volatility, even the most liquid ETFs can show significant deviations from the underlying NAV.
To gauge the magnitude of the drag (in simpler terms ‘the difference’), we use a metric called tracking difference.
Tracking difference is the absolute difference between the fund return and benchmark return. It can be calculated as
Tracking Difference = ETF return - Benchmark return
For example, if an ETF tracking Nifty 50 TRI has returned 15.9% in the last 5 years and Nifty 50 TRI itself has returned 15%, the tracking difference is 0.9%. Tracking difference can be calculated over any time period – last 1 year, last 5 years, and so on. SEBI has now mandated that ETFs (and index funds) must disclose tracking difference for the last 1 year, 3 years, 5 years, 10 years, and since inception. Tracking difference also has the same reporting problem that we discussed for the tracking error.
Tracking error is the measurement of the volatility and tracking difference is the measure of the drag in returns. It can be possible that a fund has high tracking error and lower tracking difference and vice versa. Let’s take an example to understand it better.
Below is the tracking error and tracking difference of 4 ETFs from Nippon India.
If you would have invested in Nippon India ETF Nifty 100, solely based on low tracking error, your return would have lagged the benchmark by 0.99% (annualized) over the last 5 years. On the other extreme, the tracking error for SDL ETF is 0.55% but the return has lagged the benchmark by only 0.05% (although the ETF has only been in existence for 30 months).
The broader point is that you should look at both – tracking error and tracking difference and perhaps give more importance to tracking difference as your primary focus will be on the returns and not on the volatility.
In the next article, we will see the types of ETFs available in India.
It depends on the investor's goals. If an investor is concerned about the volatility of the fund, tracking error is a better measure. If the investor wants to measure the cost of owning an ETF and is concerned about returns, tracking difference is a better measure.
You can find tracking error and tracking difference data of any ETF in the monthly factsheet provided by the AMC. You can also visit the website of AMC to find this data. For example, tracking error and difference of all Nippon India ETFs can be found here.