Reviewed by Gotrade Internal Analyst
ETFs are designed to follow an index, but they rarely match it perfectly. Over time, small gaps appear between an ETF’s performance and the index it tracks. These gaps are explained by two related but different concepts: tracking error and tracking difference.
Understanding tracking error vs tracking differences helps investors set realistic expectations about ETF investing and recognize an often-overlooked form of ETF risk.
Understanding Tracking Error and Tracking Differences
Both concepts describe how closely an ETF follows its benchmark, but they measure different things.
What is tracking error?
Tracking error measures the volatility of the difference between an ETF’s returns and its index returns.
It does not tell you whether the ETF outperformed or underperformed. Instead, it shows how inconsistent the ETF’s performance is relative to the index over time.
A low tracking error means the ETF moves very closely with the index. A high tracking error means returns frequently deviate.
What is tracking difference?
Tracking difference measures the actual performance gap between an ETF and its index over a specific period.
It answers a simpler question: how much did the ETF underperform or outperform its benchmark?
Tracking difference is usually negative because of costs, but in some cases it can be slightly positive due to factors like securities lending.
Why ETFs do not perfectly track indexes
Perfect tracking is impossible in practice.
ETFs face real-world frictions such as fees, taxes, trading costs, and cash management. These frictions create small but persistent differences from the index.
Tracking Error vs Differences in ETF
Although often used interchangeably, tracking error and tracking difference serve different purposes.
Consistency vs outcome
Tracking error focuses on consistency.
It tells you how stable the ETF’s tracking behavior is. An ETF with low tracking error behaves predictably relative to the index.
Tracking difference focuses on outcome.
It shows the cumulative performance gap, which matters for long-term returns.
Example to illustrate the difference
Two ETFs can have the same tracking difference but very different tracking errors.
One ETF may lag the index by a steady 0.3 percent each year. This produces low tracking error.
Another ETF may sometimes outperform and sometimes underperform, ending with the same 0.3 percent lag. This produces higher tracking error.
The long-term result is similar, but the experience is different.
Why investors should care about both
Tracking difference affects how much return you give up.
Tracking error affects how predictable the ETF is relative to its benchmark.
Long-term investors often focus more on tracking difference. Traders and allocators may pay closer attention to tracking error.
What Causes Tracking Differences in ETFs
Several structural factors contribute to tracking differences.
Expense ratios
Management fees are the most visible cause.
If an ETF charges 0.20 percent per year, its tracking difference will tend to lag the index by roughly that amount, all else equal.
Trading and rebalancing costs
Indexes rebalance periodically.
ETFs must trade to match index changes, which creates transaction costs and market impact that indexes do not reflect.
Cash drag
ETFs often hold small cash balances to manage inflows, outflows, or distributions.
Indexes assume full investment, so even small cash positions can create tracking differences.
Taxes and withholding
For international ETFs, dividend withholding taxes can create persistent tracking gaps.
The index may assume gross returns, while the ETF receives net dividends.
What Causes Tracking Error in ETFs
Tracking error reflects variability rather than direction.
Sampling and optimization
Some ETFs do not hold every security in the index.
They use sampling techniques to approximate performance, which can increase variability relative to the index.
Liquidity constraints
In less liquid markets, ETFs may not trade at the same prices assumed by the index.
This can increase short-term deviations and tracking error.
Market stress and volatility
During volatile periods, spreads widen and prices move quickly.
ETFs may temporarily deviate more from the index, increasing tracking error even if long-term tracking difference remains small.
How Tracking Error and Differences Affect ETF Risk
These concepts represent a subtle but important ETF risk.
Tracking risk vs market risk
Market risk comes from index movements.
Tracking risk comes from how well the ETF follows the index. Even if the index performs as expected, poor tracking can lead to disappointing results.
Impact on long-term investors
For long-term investors, consistent underperformance from tracking differences compounds over time.
Small annual gaps can become meaningful over decades.
Impact on traders and allocators
For traders, high tracking error can complicate hedging or tactical positioning.
Predictability matters when using ETFs as precise market instruments.
How Investors Should Evaluate Tracking Quality
Tracking metrics should be part of ETF analysis.
Compare tracking difference over multiple periods
Look at how closely the ETF’s returns match the index over one, three, and five years.
Persistent gaps deserve attention.
Look at tracking error in context
Higher tracking error is not always bad.
It may reflect exposure to less liquid markets or specific strategies. Context matters more than absolute numbers.
Combine with cost and liquidity analysis
Tracking quality should be evaluated alongside:
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Expense ratios
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Trading volume and spreads
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Index methodology
No single metric tells the full story.
Common Misconceptions About Tracking
Tracking metrics are often misunderstood.
Low fees guarantee perfect tracking
Low fees help, but they do not eliminate tracking differences.
Operational factors still matter.
Tracking error measures underperformance
Tracking error does not measure performance gap.
It measures variability, not direction.
Small tracking differences are irrelevant
Small differences matter over long horizons.
Compounding turns minor gaps into meaningful outcomes.
Conclusion
Tracking error and tracking difference describe different aspects of how ETFs follow their indexes. Tracking error measures consistency, while tracking difference measures actual performance gaps.
Understanding tracking error vs tracking differences helps investors better evaluate ETF risk and set realistic expectations in ETF investing. Rather than assuming all ETFs track equally well, investors should understand the sources of deviation and decide which tradeoffs matter most for their goals.
When comparing and investing ETFs on the Gotrade app, looking beyond headline performance and considering tracking quality can help you choose funds that align more closely with your investment objectives.
FAQ
What is tracking error in ETFs?
It measures how much an ETF’s returns fluctuate relative to its index over time.
What is tracking difference?
It is the actual performance gap between an ETF and its benchmark.
Is lower tracking error always better?
Not necessarily. It depends on the market, strategy, and investor use case.
Does tracking difference affect long-term returns?
Yes. Persistent underperformance compounds over time.
Reference:
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ETF Stream, Tracking Error and Tracking Difference, 2026.
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Morningstar, Tracking Difference vs Tracking Error, 2026.
