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About personal finance, investments and markets.
August 12, 2016

There is more to choosing ETFs than just fees, part 2

Buying an index fund does not, in fact, guarantee the same return as the index. In the previous blog post we wrote about the tracking difference, which is the absolute difference in returns between an ETF and its benchmark. Here we want to focus on another factor, tracking error, that is important in choosing the right ETF. Tracking error is a measure of volatility of the difference of the returns of the fund and the returns of the index. Put simply, a lower tracking error is indicative of more consistency.

Tracking error can vary widely between ETF on same index

The following table from Morningstar shows the tracking error of the largest global large-cap blend ETFs domiciled in Europe.

tracking error

Replication method impacts tracking error

The tracking error also depends on the choice of replication method. A synthetic ETF typically offers superior tracking to physical ETF. As always, there is no free lunch and the improved tracking error comes at the expense of counterparty exposure for synthetic risk. Investors need to decide for themselves if they are adequately compensated for assuming this additional source of risk. At Ipanema Capital, we prefer physical replication whenever possible.

Summary

ETF that track indexes may sound like straightforward investments. But as this and the previous blog post have shown, there can be significant differences between ETF on the same index. Tracking error and tracking differences are just two factors that we look at when selecting the best ETFs for our clients. Other factors include: bid-ask-spreads, index construction, counter party risk and taxes. If you would like to know more which ETF are best suited to help you reach your investment goals, please don’t hesitate to get in touch.

 

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