ETFs Show 6% Gap: Why Index Trackers Differ
Even though Exchange Traded Funds (ETFs) are designed to follow the same market index, they can produce different results for investors. For example, two popular ETFs that track the S&P 500 index, VOO and SPY, recently showed a noticeable difference in their performance. VOO, for instance, returned 62% year-to-date, while its benchmark, the S&P 500 index itself, returned 68%. This 6% gap, known as tracking error, is a common occurrence among ETFs.
Tracking error refers to the difference between an ETF’s performance and the performance of the index it aims to track. While it’s present in all ETFs, the size of this error can vary significantly. Understanding the reasons behind tracking error can help investors make more informed decisions.
Key Reasons for Tracking Error
Several factors contribute to why an ETF might not perfectly mirror its benchmark index. These include management fees, how the fund handles incoming cash, and the method used to replicate the index.
1. Management Fees (Expense Ratios)
One of the most common causes of tracking error is the ETF’s expense ratio. This is the annual fee charged by the fund to cover its operating costs. Even a small expense ratio can create a drag on returns over time, meaning the ETF will slightly underperform the index.
For example, VOO charges an expense ratio of 0.03%. While this seems very low, it still impacts the fund’s total return. Some ETFs, especially those that are less common or more specialized, can have much higher expense ratios, sometimes reaching 0.5% or even more. Over many years, these small differences in fees can add up, leading to a more significant gap between the ETF’s performance and the index’s performance.
2. Cash Drag
Another factor is what’s known as “cash drag.” When new money flows into an ETF, such as when investors buy more shares, the fund manager doesn’t always invest that money immediately. There might be a short period where this cash sits on the sidelines, not earning the same returns as the index. This delay in investing can also cause the ETF to lag behind the index.
Imagine a fund manager receiving a large amount of money from new investors. Before they can buy all the necessary stocks to match the index, that money sits in a regular bank account. While it’s there, it earns very little interest compared to what the stock market could provide. This lost potential return is cash drag.
3. Index Replication Methods
ETFs replicate their target indexes in different ways. Some ETFs try to own every single stock that makes up the index, in the exact same proportions. This is known as a “full replication” strategy.
However, other ETFs, particularly those tracking less common or more specialized indexes, might use a “sampling” method. This means they only buy a selection of the stocks in the index that they believe will closely match its overall performance. For broad market indexes like the S&P 500, which include hundreds of companies, most large ETFs aim for full replication. Both VOO and SPY, for example, hold all the stocks in the S&P 500.
Market Impact and Investor Considerations
For highly liquid and popular ETFs that track major indexes, like the S&P 500, the tracking error is typically very small. Differences of 6% or more, as seen in the VOO and SPY example, might be due to specific market conditions or the exact time period measured. For these large ETFs, the tracking error is usually so minimal that it’s not a major concern for most investors.
However, for smaller or more niche ETFs, tracking error can be more significant. Investors looking at these types of funds should pay closer attention to the expense ratio and the ETF’s historical tracking difference compared to its index. A larger tracking error could mean that the ETF consistently underperforms its target, even after accounting for fees.
What Investors Should Know:
- Fees Matter: Always check the expense ratio of an ETF. Lower fees generally lead to better long-term performance.
- Understand Cash Drag: Be aware that cash drag can slightly reduce returns, especially during periods of heavy fund inflows.
- Index Size: For large, well-established indexes, tracking error is usually tiny. For smaller, specialized indexes, it can be more noticeable.
- Compare Performance: When choosing between ETFs that track the same index, compare their historical performance and tracking differences.
While tracking error is a technical aspect of ETFs, its impact is real. For the average investor holding a large-cap ETF, the difference is often negligible. But for those investing in less common areas of the market, understanding these subtle performance differences can help you select the ETF that best meets your investment goals.
Source: Why ETFs Tracking the Same Index Have Different Returns (YouTube)
