Exchange Traded Funds: Toward a Tailored Selection Approach

Tracking error vs tracking difference: Does it matter?

“…On average, the index trackers collectively underperformed their benchmark by 0.7311%, ranging from a low of 0.4344% (Fidelity Emerging Markets index fund) to 1.1119% (iShares Emerging Markets ETF). The greater underperformance and larger relative risk of funds tracking international indices is consistent with previous studies (Jares & Lavin, 2004;Johnson et al, 2013;Bonelli, 2015) and is attributable to differences in trading hours between markets and exchange rate fluctuations. The magnitude of the tracking error estimates for the longer measurement horizons are similar to the one-year horizon.…”

“…Johnson et al (2013) found that certain funds in their sample consistently outperformed their indices, but this was principally due to differences in withholding taxes, as the funds were listed in different countries to the US-based indices. Overall, the estimates of tracking error and tracking difference are similar in magnitude to those obtained by Johnson et al (2013) and Bonelli (2015).…”

“…Passive investment is motivated by the belief in market efficiency which means that the average investor cannot consistently beat the market in the long-run and, as such, the core investment goal is to achieve returns commensurate with the market (Fraś & Rogowski, 2016). Several scholars and practitioners (such as Johnson et al, 2013;Vanguard, 2014;Bonelli, 2015;Pastant, 2018) thus explain that the underperformance of the fund relative to the benchmark is the key consideration for the long-term passive investor and propose tracking difference as the most appropriate measure by which to evaluate passive fund performance. However, that is not to say that some passive investors do not have a short-term investment horizon, and for these investors, performance consistency is paramount as the higher the volatility in the return difference, the higher the risk of the investor experiencing a return gap when they exit the fund.…”

“…However, that is not to say that some passive investors do not have a short-term investment horizon, and for these investors, performance consistency is paramount as the higher the volatility in the return difference, the higher the risk of the investor experiencing a return gap when they exit the fund. This deviation is only of concern for long-term investors when they wish to disinvest (Vanguard, 2014;Bonelli, 2015).…”

“…Accordingly, the objective of this paper is to assess whether these two measures result in differing conclusions about tracking performance such that investors could make different decisions if presented with one measure over the other. Johnson et al (2013) and Bonelli (2015) found that the rankings of funds vary across tracking difference and tracking error, with Johnson et al (2013) identifying a rank correlation of only 0.55 between the two metrics. This study builds on this research by reviewing the differences between tracking difference and tracking error as measures of tracking performance from a theoretical and empirical perspective.…”