What is the Tracking Error of ETF

An exchange-traded fund (ETF) is a type of investment that provides investors with a diversified investment. ETFs track a specific index, industry, or other assets. Like other investments, investors can invest in these funds in the market. Usually, ETFs include a variety of underlying investments, such as stocks, bonds, commodities, etc.

ETFs can provide investors with better returns than some other investments. Since these funds track a specific index, industry, commodity, or other assets, investors can expect similar returns. However, there are some risks specific to investing in ETFs that investors need to consider. One such risk is the tracking error of ETFs. Before understanding how these affect ETFs, it is crucial to know what tracking errors are.

What is a Tracking Error?

Tracking error refers to the difference between the variance in returns from an investment portfolio and a chosen benchmark. In other words, it represents the relative risk of an investment portfolio compared to its benchmark. The variance between these returns comes in the form of standard deviations. Tracking errors can have a significant impact on the returns that investors can expect from their investments.

Tracking errors are common for investments that track a specific benchmark. These may include exchange-traded funds, mutual funds, etc. Tracking error can help investors gauge the performance of an investment and help compared it with a benchmark. In that context, it can also help investors measure the performance of fund managers.

What is the Tracking Error of ETF?

As mentioned above, ETFs are funds that usually track an index. The tracking error of ETF represents the difference between the returns from this index and the actual returns of the index fund. Several factors may contribute to it. In most cases, however, the tracking error of ETFs are minor. However, these errors almost always exist and are rarely nil.

The tracking error of ETF can be significantly critical to investors. Since investors measure an ETF's performance, it can provide insights into the ETF's consistency against the tracked index. It also provides them with a base to measure an ETF manager's performance. Overall, investors can gauge the volatility in the difference between an ETF and its index using tracking errors.

How can investors calculate the Tracking Error of ETF?

As mentioned above, tracking error represents the difference between the returns from the fund and those of its index. Therefore, investors can calculate the tracking error using the following formula.

Tracking Error = Return(P) - Return(i)

In the above formula, Return(P) represents the returns from the ETF or portfolio. On the other hand, Return(i) signifies the returns from the index. However, the above is one of the two methods which investors can use to calculate the tracking error. In addition to the above, investors can also use the following tracking error formula.

Tracking Error = Standard deviation of (P - B)

In the above formula, ‘P’ represents the returns from the portfolio or the ETF. On the other hand, ‘B’ signifies the returns from the benchmark or index.

Conclusion

Exchange-traded funds are investment funds that usually track a specific index. However, the returns on these funds may differ from those of the index. This difference is known as the tracking error of ETF. Tracking errors can be significantly beneficial for investors to gauge an ETF's performance. Investors can calculate it using one of the two methods given above.

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