Tracking ETF Performance

To determine the percent return, divide the total return by the amount you invested in the fund. This percentage allows you to compare the performance of one investment against similar options and relevant benchmarks.

Tracking the performance of your core ETF holdings is relatively straightforward. Percent returns over different time frames—from a single day to three years or longer—are readily available on the fund sponsor’s website, financial news sites, and rating services. Returns for periods longer than one year are often annualized to show a per-year basis.

Keep in mind that your actual return may differ from reported figures due to factors such as the timing of your purchase and sale of shares, as well as any commissions paid. Additionally, newer ETFs may have less reliable performance records due to their shorter history.

Without a full market cycle of both gains and losses, it’s difficult to assess whether a fund has been more or less volatile compared to the overall market or, for a sector-specific ETF, compared to its particular sector.

How do ETFs attempt to track index performance?

An index measures the performance of a specific market or sector, helping gauge how well or poorly that segment is performing based on changes in the index’s value.

ETFs (exchange-traded funds) are often designed to replicate the performance of an index. Essentially, indexed ETFs invest in the same assets as the index they track, aiming to mirror the index’s movements proportionally. Over 70% of ETF investments are intended to track a benchmark index.

ETFs can track indexes in various ways, reflecting the diversity and characteristics of the underlying market or sector. Some indexes are more diversified than others, and understanding the exposure and diversification of the index an ETF tracks is crucial.

The most common type of index is the market capitalization (cap) weighted index, where the weight of each security is based on its market value. In contrast, fundamental indexes weight securities according to financial metrics like revenues or dividends. Equal-weighted indexes give each security an equal share, while low volatility indexes aim to minimize fluctuations. Multi-factor indexes combine several investment principles, whereas single-factor indexes rely on one investment assumption.

What is the tracking difference?

Most ETFs aim to closely mirror the performance of a specific index, but the returns they deliver often differ from those of the index, a discrepancy known as the tracking difference. Typically, ETFs lag slightly behind their index, and achieving a zero tracking difference is uncommon.

This tracking difference arises because an ETF can only partially replicate its index due to various factors. The total expense ratio (TER) of an ETF is the most reliable predictor of this tracking difference. For instance, if an ETF has a TER of 1%, its returns are expected to fall short of the index’s returns by approximately 1%, assuming other conditions remain constant. Consequently, ETF issuers strive to minimize fees to keep tracking differences as small as possible.

However, tracking difference can be influenced by other factors beyond TER. ETFs that track indexes with many securities, illiquid assets, or frequently rebalanced portfolios tend to have larger tracking differences due to higher transaction and rebalancing costs. When an index rebalances, adds, or removes companies, the ETF must adjust its holdings accordingly, which can create discrepancies.

Additionally, “cash drag” occurs when an ETF holds cash from payouts before reinvesting it. This temporary holding of cash or the costs of reinvesting dividends can also contribute to tracking difference, causing the ETF’s performance to deviate slightly from the fully invested index.

What is a tracking error?

An ETF’s performance primarily mirrors the value of its underlying investments, as dictated by its index. For example, a SPDR ETF tracking the capitalization-weighted S&P 500 will reflect the index’s fluctuations. Similarly, a commodity ETF’s performance follows the movements in the value of futures contracts for the underlying commodity, rising with the commodity’s price and falling when the commodity’s value decreases.

However, the underlying investments are not the whole picture. Factors such as fund expenses and management practices can influence the ETF’s return, potentially causing it to diverge from the index it seeks to replicate. This divergence is known as tracking error. A smaller negative tracking error—where the ETF’s return falls short of the index’s return—is generally preferred by both investors and fund sponsors.

To minimize tracking error, compare the fees and expenses of different ETFs tracking similar market segments. The expense ratio provides a snapshot of comparative costs, representing the annual percentage of assets spent on administrative and investment expenses. Additionally, consider other factors impacting returns. For instance, ETFs tracking indexes with frequent component changes may incur higher transaction costs, which are not reflected in the expense ratio, and contribute to a higher tracking error.

How to track exchange-traded funds (ETFs)?

Thanks to their open-ended structure, ETFs allow fund managers to issue additional units as investor demand increases. This mechanism helps ensure that ETF prices closely align with the value of their underlying assets, unlike listed investment companies that can trade significantly above or below their Net Asset Value. Additionally, since ETFs are traded on stock exchanges, tracking their performance is straightforward, akin to monitoring other stocks, unlike managed funds which might have less transparent pricing.

For ETF performance data, you can explore the following resources:

• ETF Database: Offers daily updates on ETFs, a comprehensive database of U.S.-traded ETFs, a free screener, and various tools, including a comparison analyzer and a mutual fund to ETF converter.
• Morningstar: Provides extensive ETF information, including a screener. While basic information is free, detailed research requires a subscription.

What are risks and returns?

The return of an ETF is directly linked to the level of risk it entails, a fundamental principle of investing. Generally, higher potential returns come with greater risk. While some risks are predictable—such as market cycles that go through recurring patterns of highs and lows—the exact timing of these cycles is uncertain. To mitigate this, diversifying across different asset classes and subclasses, which ETFs facilitate easily, can help manage both predictable and unexpected risks.

Investing in diversified ETFs helps reduce the impact of specific risks associated with individual companies, such as management and credit risks. Additionally, incorporating ETFs that track more specialized or alternative indexes can provide opportunities for above-average returns without the need to pick individual stocks within a sector. However, it’s crucial to thoroughly understand the risks associated with any ETF before investing.

Tracking ETF Performance by Inna Rosputnia

Wishing you a great week!