Tracking Error
All ETFs track a particular benchmark, so ideally the ETF should return the same its benchmark returns. However, in most cases there is a difference between the return from the ETF and that from the benchmark, with the ETF usually returning slightly less than the benchmark. This difference is called the tracking error which is one of the most important numbers to consider while comparing ETFs.
For example, if the sensex returned 15% over one year and the ETF tracking the sensex returned 14.8%, then the tracking error is 0.2%. Although looks minuscule, over several years this tracking error could prove to be a large number. Usually tracking error is measured by standard deviation, a popular statistical formula.
Some of the reasons for tracking error are expense ratio, transaction and rebalancing costs, the time when it receives dividend from its portfolio companies and when it deploys or distributes that money etc. Ideally investors should look for positive tracking error in an ETF, and if not then the lowest tracking error.
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