Just as there are numerous ways to create an index, there are multiple ways for an ETF to attempt to track the performance of an index.

How to Evaluate ETF Performance?

Knowing what you are looking for is a big part of investigating investment performance. In most cases, it’s total return, which you calculate by adding any change — up or down — in share price to any dividends or interest the investment paid.

If you divide the total return by the amount you invested in the fund, the result is a percent return. You can use this figure to compare the results for one investment to similar investments and the appropriate benchmark.

Monitoring the performance of your core ETF holdings is relatively easy. You can find percent returns over various periods online at the fund sponsor’s website, on financial sites, and through rating services. Return results for various periods, from one day to three years or as long as a particular ETF has been operating, are computed using the sponsor’s information. Results for longer than a year are annualized to provide a per-year basis.

Remember, though, that your actual return, whether realized or not, may be different from what’s reported based on fund statistics. Among the reasons are the timing of the purchase and sale of shares and the amount of commission you paid if any.

In addition, the newer an ETF is, the less informative its performance record will be.

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Unless a fund has been in operation through a full market cycle of gains and losses, you can’t evaluate whether it has been more or less volatile than the market as a whole or, in the case of a narrowly focused ETF, than its sector.

How do ETFs attempt to track index performance?

An index tracks a specific market and measures that market’s performance. Depending on how the index’s value changes, you may determine how well (or poorly) that particular stock market is doing.

ETFs, or exchange-traded funds, are frequently created to replicate an index’s performance. In essence, these indexed ETFs invest in the assets held by the index in a way that ensures that the ETF increases or decreases by roughly the same relative proportion as the index does. More than 70% of the funds invested in ETFs intend to track a benchmark index.

An ETF can monitor an index’s performance in various ways, just as there are numerous ways to construct an index itself. Various market characteristics, from broad markets to particular market capitalizations or sectors, can be used to base the indexes that ETFs track. By design, some indexes are less diversified than others, and vice versa. Determining the exposures and amount of diversification of the underlying index that a particular ETF seeks to track is therefore crucial.
A market capitalization (or “cap”) weighted index is the most popular kind of index.

Here, the weights of the underlying securities are determined by how much of the market they represent. A fundamental index may weigh each security based on a rating system of the underlying company’s financial data, including revenues, sales, and dividends, as opposed to equal-weighted indexes, which assign each security an equal share of the index. Some securities are weighted in low volatility indexes that aim to reduce the index’s overall ups and downs. Finally, a multi-factor index incorporates several investment principles, whereas a single-factor index is based on just one assumption about investing.


Enhanced ETFs, whose sponsors seek to outperform the market by using indexes that include only the strongest performing securities within a market segment rather than its entire universe, may run the risk of greater losses in a falling market because their underlying indexes are more volatile than those that are passively managed.

What is the tracking difference?

Most ETFs aim to track an index, which means they try to provide returns similar to that of a specific index. The difference between the performance of an index and an ETF is known as the tracking difference. In most cases, the ETF trails behind its index; the tracking difference is rarely zero.

This is because the ETF can only partially replicate its index for several reasons. However, ETF returns may not necessarily trail behind their index; the tracking difference could be small or large, positive or negative.

The total expense ratio of an ETF is the most accurate predictor of future tracking difference (TER). If an ETF charges 1% to track an index, then its returns should trail the index’s returns by precisely 1%, all other variables being equal. As a result, TER is essential, and ETF issuers try to impose the lowest fees. Other factors come into play even if TER is the best predictor of future tracking difference.

Due to higher transaction and rebalancing costs, ETFs that track indexes with several securities, illiquid assets, or often rebalanced portfolios will have a wider tracking difference. The holdings of the ETFs that track an index must be changed to reflect the index’s current status whenever the index rebalances its constituents, adds a new firm, or removes a company.

The “cash drag” for the ETF is when it receives a payout and when it makes those payments to owners. Investment managers can reinvest those dividends in the short term, but doing so incurs costs. Due to holding a portion of its portfolio in cash or performing reinvestment operations, the ETF will have slightly different returns than the fully invested index, resulting in tracking difference.

What is a tracking error?

An ETF’s performance is based primarily on what is happening with its underlying investments, as reflected in the ETF’s index. For instance, the return on the SPDR that tracks the stocks in the capitalization-weighted S&P 500 can be expected to reflect changes in the index’s value. A commodity ETF tracks what’s happening with that underlying commodity as reflected in the changing value of futures contracts — increasing in value when the commodity’s price increases and drops if the commodity loses value.

But the underlying investments don’t tell the entire story. For example, fund expenses and management practices, such as how quickly a stock ETF reinvests cash dividends and capital gains, can mean an ETF’s return varies from the return of the index it aims to duplicate.
This gap is called a tracking error. The smaller the negative tracking error — the amount an ETF’s return trails that of the index — the happier investors and fund sponsors are. To help ensure that the negative tracking error on the funds you buy is minimal, you should compare fees and expenses for different ETFs tracking similar market segments.

You can get a snapshot of comparative costs by looking at each fund’s expense ratio, which is the percentage of the assets you pay each year in administrative and investment expenses. Also, you will want to investigate any other factors that can impact return. For instance, an ETF that tracks an index whose components change frequently may have a higher tracking error because its transaction costs – which aren’t included in the expense ratio — are higher.

How to track exchange-traded funds (ETFs)?

Due to the open-ended nature of ETFs, the fund management (or issuer) may release more units to the exchange when investors request more units of the fund. Therefore, ETFs trade at a unit price that is involved in getting to the value of each unit’s underlying assets, as opposed to listed investment companies that can move significantly above or below their Net Asset Value. Furthermore, as ETFs are listed (and traded) on stock exchanges, tracking their performance is similar to monitoring any other stock, unlike managed funds, which may have opaque price discovery.

You can find ETF performance information online at these and other sources:

  • ETF Database provides daily coverage of ETFs, an extensive database of ETFs traded in the United States, a free screener of the ETFs in that database, and a variety of other tools, including an analyzer to compare ETFs and a mutual fund to ETF converter.
  • Morningstar has a full range of information about ETFs, including an ETF screener. While some information is free, in-depth research is available only to paid members.

What are risks and returns?

The return an ETF provides is directly related to the risk it carries, a relationship characteristic of every investment you make. Investments with the highest potential return invariably expose you to the greatest risk. Certain risks are predictable. Markets and the ETFs invested in them move through recurring patterns of ups and downs. Because the nature of those cycles is predictable, even though their timing isn’t, you can benefit from and help offset their impact by investing across various asset classes and subclasses – something that ETFs make easy.

By investing in diversified ETFs, you can also reduce the impact of the unexpected risks that may be posed by individual corporations: management risk and credit risk, for example. And by adding ETFs that track narrower indexes or alternative investments, you can add the potential to capitalize on above-average returns in the short term without having to select individual investments within a specific sector. What you don’t want to do, however, is invest in any ETF without fully understanding the risks to which it could expose you.

Tracking ETF Performance by Inna Rosputnia

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