As if investors didn’t already have enough reasons to steer clear of exchange-traded funds (ETFs), new data show that the funds’ average tracking errors are on the rise.
A fund’s average tracking error is the difference between its return and its benchmark index’s return. Most ETFs (not including inverse or leveraged ETFs) attempt to match as closely as possible the returns of their underlying benchmarks. This means that if a particular ETF tracked the S&P 500 and the S&P 500 gained 13.4% in 2012, then a well-managed S&P 500 ETF should theoretically render an investor a return of 13.4% minus the fund’s expense ratio. In practice, however, this isn’t always the case.
In fact, the average ETF’s tracking error for 2012 was 59 basis points, according to InvestmentNews. That reflects an increase from 2011, when the average tracking error was 52 basis points.
Higher than average expense ratios will necessarily translate into higher than average tracking errors, but ETFs based on illiquid indices also tend to have greater tracking errors than ETFs based on bigger, more liquid indices. Investors who decide to invest in ETFs should make sure they fully understand the products’ risks, including a particular fund’s average historical tracking error.
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