Something I’ve been big on lately is ETF tracking error. An ETF’s ability to track an index can be a bigger cost (implicit cost) to an ETF, and investors should be very concerned with this. This ability of an ETF to track its index is the tracking error, measured by standard deviation from the index. It measures how well the ETF’s managers design and create the Net Asset Value (NAV) of the ETF to replicate the index’s performance. Market prices can also be used to measure tracking error and are more appropriate in some cases. This is the objective and goal of any ETF. Of course, no one cares when the ETF has a positive tracking error, returning better performance than the index, but where an ETF has a large positive variance from the index, there is also potential for negative variances. Investors need to be aware of this.
Most notably, there were many emerging market ETFs in the list from all the major ETF providers; SSgA, iShares, and PowerShares. Preferred Stock and individual real estate sectors seem to be broadly included in the worst list. Also, the TDAX Independence Lifecycle Funds were included in the list with large tracking errors. However, these ETFs cover some different indexes designed by Zacks.