Most ETFs track indexes. This means that ETF investors can understand exactly how much it costs, all-in, to hold an ETF. ETF investors expect to get the index returns, minus fund expenses, with no surprises.
But, it turns out there’s a lot more to this story than you might expect. To tease out how well run – or how complex – an index-tracking ETF is, we generally turn to tracking difference; the performance gap between the ETF’s Net Asset Value (NAV) returns and the returns of its underlying index. Alas, this measurement can be not just useful, but maddening.
In a perfect world, tracking difference tells the investor the exact difference between expectations (index performance) and reality (NAV total returns), excluding any trading costs. All else equal, we would expect tracking difference to equal the net expense ratio, plus portfolio management slippage, minus foreign dividend tax recapture, minus securities lending revenue. The problem is that all else is not equal. And it gets worse when NAVs are calculated asynchronously vs. the underlying index.
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First off, the actual ex-post expense ratio might not equal the ex-ante ratio stated in the prospectus.
Second, portfolio management slippage is real, but generally not made available to the public.
Third, foreign dividend tax re-capture might not square with the underlying index’s applied withholding rate.
To cap it all off, some issuers calculate NAVs for non-U.S. equity funds using exchange rates taken at 4:00 p.m. ET, rather than the standard WM Reuters 4:00 p.m. GMT (10:00 a.m. ET).
Put that all together, and you have a bit of an interpretation problem.
Where Tracking Difference Works
Nevertheless, tracking difference remains a quite useful tool. Here’s a few ways you can look at it:
First, a simple case, where tracking difference tells you all you need to know about long-term holding costs; the three S&P 500 ET