Exchange-traded funds (ETFs) have become immensely popular among investors for their simplicity, diversification, and low expense ratios. However, there’s a hidden expense that’s easy to overlook but can cost you thousands of dollars over time. It’s the tracking error. Here’s a breakdown of what a tracking error is and how you can avoid getting caught in its profit-eroding trap.
What is a tracking error?
In a perfect world, an ETF would match the index it tracks. For example, if you purchase a broad-market ETF tracking the S&P 500, that ETF’s gains should mimic those of the S&P 500. If the ETF consistently earns less (or more) than the index, the difference is due to a tracking error. A high tracking error rate means the ETF is not doing a good job of following the index, and that could cost you money in the long run.
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How a tracking error impacts your investment
Tracking errors can slowly erode the value of your portfolio. Here’s how:
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Loss of compounding: Let’s say the S&P 500 index earns 10% in a year, but the ETF you own that tracks the S&P 500 only earns 7%. That 3% difference is gone, along with the gains it would have compounded over time.
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Fees: While many ETFs have low expense ratios, not all of them do. Simply put, some have higher management fees than others. If you’re holding an ETF with higher-than-average fees, you may find that your returns lag significantly behind the index your ETF tracks.
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Tax implications: To maintain alignment with their benchmarks, all ETFs need to be rebalanced periodically. The issue is that rebalancing can lead to additional expenses, including potential capital gains distributions that may be subject to tax. Unexpected taxes are another expense that creates a gap between the benchmark’s year-end return and your ETF’s gains.
How to mitigate the impact
These three strategies can help you minimize the impact of tracking errors on your portfolio:
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Choose low-fee ETFs: One of the easiest ways to mitigate tracking errors is to choose ETFs with low expense ratios. The lower the fee structure, the higher the net results tend to be.
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Diversify: Diversifying investments across multiple ETFs is an effective way to reduce the impact a tracking error has on your overall balanced portfolio.
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Monitor: Compare the ETF’s performance to its benchmark every few months. If you regularly notice a gap between the two, you know there’s an issue with tracking errors.