Tracking Error

Tracking error measures how much a fund’s returns deviate from the index it’s designed to follow. If an ETF tracks the S&P/TSX Composite and the index returns 8% in a year but the ETF returns 7.8%, the tracking difference is 0.2%.

What causes it

The most common cause is fees. A fund’s MER is deducted from returns, so a fund will almost always trail its benchmark by at least the amount of its fees. But other factors contribute too:

• Cash drag: Funds hold a small amount of cash for day-to-day operations, and that cash doesn’t earn the index return.
• Sampling: Some funds don’t hold every single security in the index. Instead, they hold a representative sample, which introduces small differences.
• Rebalancing timing: When an index adds or removes a stock, the fund needs time to adjust. Buying or selling at slightly different prices creates small deviations.
• Securities lending: Some funds lend out shares to short sellers and earn income from it, which can actually reduce tracking error by offsetting fees.

Why it matters

For index funds and passive ETFs, low tracking error means the fund is doing its job well. If two ETFs track the same index but one consistently lags further behind, it’s effectively costing you more. When comparing similar funds, looking at tracking error over several years gives you a more complete picture than MER alone.