As of this year, providers of index-tracking UCITS exchange-traded funds (ETFs) will be required by European regulation to disclose ex-ante predictions of their ETFs’ tracking error and tracking difference. Providers will also have to explain any divergence between their predictions and the ETFs’ actual performance.

Tracking error and tracking difference measure the quality of index replication, i.e. how well an ETF replicates the performance of its target benchmark index.

Tracking error and tracking difference measure the quality of index replication, i.e. how well an ETF replicates the performance of a specific index. Investors typically expect their ETF to adhere tightly to an index.

Tracking error is a measure of the standard deviation of a fund’s excess returns. ESMA’s consultation paper defines tracking error as “the volatility of the difference of the returns of the fund and of the returns of the index.” Tracking difference is simply the absolute difference in returns between an ETF and its benchmark over a period of time.

In recognition of these new European reporting requirements, Morningstar’s European Passive Fund Research team has produced a report, entitled ‘On the Right Track: Measuring Tracking Efficiency in ETFs’, which examines the factors that influence tracking error and tracking difference in ETFs.

Among the key findings of the report are that, in general, ETFs have done well in limiting tracking error. For example, European-listed ETFs tracking the FTSE 100 index had an average weekly tracking error of just 0.06%; ETFs tracking the S&P 500 and DAX indices managed to keep to 0.04% on average.

The report found that ETFs using synthetic replication (usually implemented via a swap) typically produce lower tracking error than those using physical replication. However, there is less of a direct relationship between tracking difference and a fund’s replication method.

Total Expense Ratio (or TER) is the most predictable and easily quantifiable factor affecting a fund’s performance relative to its benchmark. Nonetheless, it is not the only one and, in some cases, may not even be the most important.

Securities lending income, cash drag, tax optimisation, rebalancing costs for physical ETFs and swap fees for synthetic ETFs can also impact a fund’s relative performance.

Contrary to popular belief, the relationship between tracking error and tracking difference is not particularly strong. As an alternative tracking metric, Morningstar proposes an approach, called Estimated Holding Cost, which seeks to offer a smoother and more reliable measure of an ETF’s performance relative to its benchmark after all holding expenses and revenues.

Hortense Bioy, director of European passive fund research for Morningstar and co-author of the report, said: “Tracking error and tracking difference both play a part as complementary measures for assessing the replication quality of an ETF. As ETFs continue to gain in popularity, there is an increasing need for investors to be clear about these most commonly used metrics. In particular, there seems to be considerable confusion around tracking error, its meaning, key drivers, and calculation.”

She added: “Beyond the definition provided last year by ESMA in its final guidelines on ETFs and other UCITS, we believe that investors would benefit from a harmonised approach to calculating tracking error. Our report intends to open up this discussion.”

Of course, beyond all tracking metrics, product and index construction, counterparty risk, bid-ask spreads, brokerage commissions, and tax considerations are some of the additional factors that should be considered by investors when evaluating an ETF.

To read the full report click here: On the Right Track – Measuring Tracking Efficiency in ETFs.