Understanding ETF costs: Why tracking error matters more than expense ratios

Understanding ETF costs: Why tracking error matters more than expense ratios

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When it comes to ETF (Exchange-traded fund) investments, most investors focus on expense ratios- the percentage of a fund’s assets charged annually for managing the fund. While expense ratios are an essential consideration, the tracking error often holds more significance in determining the actual performance of an ETF. For informed investing, it’s crucial to understand how these costs affect your returns and why the tracking error can be a more telling factor in evaluating an ETF’s efficiency.

What are expense ratios?

The expense ratio of an ETF represents the annual fee charged by the fund for administrative, management, and operational costs. Expressed as a percentage, this cost directly reduces the fund’s returns.

For example, if an ETF delivers a 10% return and has an expense ratio of 0.5%, your net return will be 9.5%. Lower expense ratios are generally considered favourable, especially for long-term investors, as they help preserve more of your returns over time.

What is tracking error?

Tracking error measures the difference between an ETF’s actual performance and the performance of its benchmark index. Ideally, an ETF should closely replicate its benchmark, but factors like management inefficiencies, transaction costs, or liquidity issues can cause deviations.

For instance, if an ETF tracking the Nifty 50 delivers a return of 9.8% while the index grows by 10%, the tracking error is 0.2%. Smaller tracking errors indicate better fund management and higher accuracy in following the index.

Why is the tracking error so important?

Represents real performance

While expense ratios provide an estimate of annual costs, the tracking error reflects the fund’s actual performance relative to its benchmark. A fund with a low expense ratio but a high tracking error may not deliver the returns you expect.

Impacts long-term returns

Over time, even a slight deviation caused by the tracking error can significantly affect your wealth. For long-term investors, a consistently low tracking error is more beneficial than marginally lower expense ratios.

Reveals fund efficiency

A low tracking error indicates that the fund manager effectively replicates the index, keeping the investment on track. High tracking errors, on the other hand, may signal inefficiencies or hidden costs.

Factors contributing to the tracking error

  • Trading costs: Frequent buying and selling of securities to mirror the index can incur higher transaction costs.
  • Cash drag: ETFs often hold some cash for redemptions, which may lead to underperformance compared to a fully invested index.
  • Dividend management: Delays or inefficiencies in reinvesting dividends can cause discrepancies.

How to evaluate ETFs

When making any ETF investment, consider both the expense ratio and the tracking error. Here’s how:

  • Look for ETFs with low expense ratios, especially for passive funds.
  • Compare tracking errors among ETFs tracking the same benchmark.
  • Assess fund size and liquidity, as larger funds tend to have lower tracking errors.

Conclusion

While expense ratios remain a visible and easy-to-compare metric, the tracking error provides a clearer picture of an ETF’s actual performance. An ETF with a slightly higher expense ratio but a minimal tracking error can often deliver better results than one with a low expense ratio but poor index tracking.

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