4 Causes of ETF Tracking Errors

When it comes to ETF tracking errors, there are a number of sources that could contribute to discrepancies between the financial index and the ETF that tracks it. If you invest in an ETF index fund, you are usually interested in getting the same returns as the index. In reality, most ETFs lag a little behind the indexes that they try to track. Here are a few causes of ETF tracking errors.

1. Fees

The fees of an ETF are perhaps the most prominent reason that the real performance lags behind the index. Every ETF has management and administrative costs that must be covered. These costs are paid for by the fees that they charge investors. These fees are taken right out of the returns from the gains of the fund. This lowers the amount of money that is made by investors. In many cases, ETF's are very efficient and do not have very high fees. However, they have to charge something which limits the amount of return.

2. Execution

The basic idea of an index fund is relatively simple. The fund tries to purchase the stocks that are in the index and sell the ones that are removed from it. This provides returns that are much like the returns of the financial index. When it comes time to put this strategy into practice, there is usually a little bit left to be desired. You have to be able to get instant execution on orders of stock when one is entered into the index. If the order lags, you will not copy the performance of the index exactly. Many times, ETF's have to buy many thousands of shares of a particular stock at once. If there are multiple ETFs, or mutual funds, that track the same index, everyone will be competing for the available shares. This can drive up the price of the security and lower the return.

3. Optimization

Some ETF's try to use optimization strategies in order to slightly beat the index. They use active management techniques to put more weight into certain aspects of the index. When this happens, you are essentially relying on the ability of the fund manager to make the right decisions and invest in the right securities. If they make the wrong decisions, it can lead to losses for the portfolio and the returns will be less than the actual index that it is tracking.

4. Cash Management

Another area that tends to skew the results of an ETF is the cash management. ETFs have a certain amount of cash that they have to deal with from dividends and other sources. How the ETF manager chooses to handle that cash will have a big effect on the performance of the fund. Stock indexes do not have any cash reserves, so anytime it is held in an ETF portfolio, it means that the portfolio is not an exact representation of the index.

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