On the Right Track: Measuring Tracking Efficiency in ETFs

Abstract

Exchange-traded funds (ETFs) are, with the exception of certain actively-managed products, designed to track the performance of an index. This concept is easy to understand, but putting it into practice is far more difficult than it seems. While indexes are typically replicable in theory, index returns are an unattainable ideal, as they ignore the practicalities of portfolio construction and ongoing management. There will always be factors involved in the replication process that will cause mis-tracking, and investors should be aware of these realities and arm themselves with the knowledge of where performance deviations originate and how to measure them.