ETF essentials · 2 minute read
Tracking difference: does the ETF deliver what it promises?
The short answer
Tracking difference is the gap between an ETF’s return and the return of the index it follows. It helps you see how the ETF has performed after costs and other effects.
Why it matters
An ETF does not usually match its index exactly. Its return can be affected by:
- The annual fund operating charge (TER) and other expenses
- Trading and rebalancing costs
- Taxes on dividends
- The way the ETF replicates the index
- Fees earned by temporarily lending investments to other institutions
- Timing differences between markets
A low TER is useful information, but it does not tell you the full story. Tracking difference can provide a better indication of the result investors actually received compared with the index.
A simple example
If an index rises by 10% over a year and an ETF rises by 9.7%, its tracking difference is approximately -0.3 percentage points for that period.
That gap may be broadly in line with expectations for the fund’s costs. A larger or inconsistent gap may need further investigation.
What to check
- How closely has the ETF followed its index?
- Has the gap been reasonably consistent?
- Is the comparison made over a sensible time period?
- Are the ETF and index returns measured in the same currency?
- Could tax, market timing or index changes explain the difference?
Key term explained
Tracking difference is the actual performance gap between an ETF and its index. Tracking error usually refers to the variability of that gap over time.
TER is already part of the costs affecting tracking difference. Adding both as separate charges would double count that cost.
Past tracking does not guarantee future results, but it is useful evidence when comparing similar ETFs.