Article 109: Exposure and Tracking Error: Big ETF Terms That Help With Assessing a Fund Quicker

What are the key metrics you look at when you are assessing a fund? Continuing from my last post, I will look at the next things I look at when I am assessing a fund, stick around, this week I am talking about the underlying index and tracking it.

What are the key metrics you look at when you are assessing a fund? Continuing from my last post, I will look at the next things I look at when I am assessing a fund, stick around, this week I am talking about the underlying index and tracking it. 

Many people believe that all indices are the same, an example being is S&P500 an index I mention often, and the Russell 1000, what is the difference? From the number you can probably guess that S&P500 contains 500 companies while the Russell 1000, contains, you guessed it, 1000. That is twice as many but over any given period the 2 perform just about the same (see the chart of total returns of the last 3 years below).

Inline image

That said, it may appear as though I am pointing out that the underlying index does not matter, well, this is a rare case.

The Dow Jones Industrial Average holds 30 stocks and does not look or perform anything like the S&P 500. You could be tracking a “financial” index in china while you are under the impression you are tracking “the Chinese stock market”. It is great that most ETFs disclose their holdings (I’d avoid the ones that don’t, because I do not want to invest in a BlackBox), You can see what sectors, companies, countries are in the ETF. This lets you know what Exposure you are getting and make sure it matches what you have in mind. If you wanted exposure to the broader US stock markets, there is no point getting an ETF that only has US Banks in it

I pay attention to what assets the ETF holds as well as the weightings. Some indices weigh their holdings equally while others allow a few big names to carry the bulk of the performance (an example is Cathie Wood’s ARK investment which has a heavy dose of Tesla). Some will aim for broad market exposure and others will try to outperform the index. You should know what any ETF you own is doing, and not assume the name alone is an accurate representation of what they do (many times they are not). As we have seen recently, a clean energy business like Tesla can hold Bitcoin which is not very environmentally friendly.

Tracking Error (The lower the better):

After the exposure is confirmed to be what you want, the tracking error (also called tracking difference) is what I look at in conjunction with Exposure. From my last post, you know I like my Expense Ratios low, but that is not the end of it because good value is in what you get for the price you pay (not just the price). And ETF should track the index very closely, if it rises 20% then my gains should be 20% (it is bad enough that the expense ratio means you will rarely even get the exact amount, but your tracking and expense ratio should still leave you close to the actual return of the ETF). Consider that if the tracking error is 5%, it could mean that your return on 20% gains by the index, could be down to 15% which means that tracking error can be more damaging than even your expense ratio. So I would avoid an ETF with a lower expense ratio if the tracking error is significantly larger than the tracking error of another ETF tracking the same index.

Popular indices like S&P500 get very good tracking because funds can buy every single security in the index in the appropriate weighting also applied (so apart from the transaction cost of buying them) you should get perfect tracking. This is called “Full Replication”

Another tracking method is called “sampling” and this is where the manager buys some, not all, of the instruments in the index (e.g Buying the biggest 400 out of 500 companies). This will have fewer transaction fees to pay for tracking but is not going to give perfect replication of the performance of the index. It may outperform or underperform the index, and when your goal is to match the index depending on what items are selected to represent the index, outperforming or under-performing are not great.

The lower the tracking difference (especially when under-performing the index) the better.

To Summarize

I like to know what I am buying:

What is this giving me (Exposure) and how well does it give me the exposure (Tracking Difference)

Look at the underlying benchmark to know what exposure you are getting, look at the tracking difference to see how well it delivers that exposure.

My Question from last time: Do you think you can capture all the gains of the US stock markets without buying shares? Yes, you can with an ETF that tracks the US markets. Ask me for a name if you like, email me:  

Remember, these are all for educational purposes and are not investment advice.

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