Tracking error vs tracking difference

The majority of investors tend to look at tracking error when deciding which Exchange Traded Fund (ETF) to invest in, but is this the correct measure to evaluate a fund’s performance? The answer to this question is both yes and no. The aim of this article is to explain the differences between tracking error and tracking difference so that one can understand what each measure represents, and most importantly, the information that these measures provide investors to assist in their decision making process.

Tracking difference measures how a portfolio performs compared with the benchmark that it tracks over a specific period,
for example, the Ashburton Top40 ETF which tracks the FTSE/JSE Top40 Index. The difference between the performance of the Ashburton Top40 ETF and FTSE/JSE Top40 Index will constitute tracking difference and the difference can be due to many factors which will be explained further in this article.

Tracking error measures the consistency of a portfolio’s tracking difference during a specific period. It is calculated by using the annualised standard deviation of the difference in the portfolio and the benchmark returns over time.

The aim of a tracking index ETF is to deliver the performance of the index benchmark that it tracks. In order to determine how well the ETF has performed, the tracking difference needs to be considered. It is seldom that an ETF achieves perfect tracking. Tracking difference can at times be positive or negative, which indicates whether the fund outperformed or underperformed its benchmark. A low tracking difference over time means a portfolio has done well on its investment objective, whereas a low tracking error indicates that a portfolio is closely following its benchmark.

There are many factors that play a part in determining the tracking difference of a fund, these include, total expense ratio (TER), trade execution costs, management fees, cash drag, foreign exchange rate volatility and rebalancing costs.

The Ashburton Top40 ETF achieved second place at the SALTA (South African Listed Tracker Awards) for tracking efficiency in South African Equity. It is one of the best performing funds in its category, offering one of the lowest fees in the market with management fees of 0.085% and a low TER of 0.14%. The TER is a good indicator for future tracking difference. Exchange Traded Funds with low TERs are well positioned to track their benchmarks closely.

It is important to note that when assessing ETFs, tracking error and tracking difference are not the only measures that must be taken into consideration. These are only two of multiple measures and should be used in conjunction with other measures such as TER. So, when deciding which ETF to invest in, it is important to look for low TERs with a low tracking difference over time.