Understanding ETFs
September 20, 2023
Many components make up the total cost of ownership of an exchange-traded fund (ETF), including expense ratios, bid-ask spreads, and premiums and discounts. Tracking error tends to be overlooked, but because it impacts investment returns, it, too, is a cost. And it’s a central issue for all index funds, not just ETFs.
The root cause of tracking error is inherent in the nature of all indexes—which are theoretical constructs only, free of any real-world costs. They cannot be invested in directly. Managers of index funds and ETFs must deal with frictions and challenges that, if not handled well, can lead to substantial performance differences from the pure index. These involve transaction costs, sampling differences, timing of cash flows, and differences in local-market timing schedules. Asset managers who offer index products are constantly improving and refining how they reduce the impact of such frictions.
Why tracking error is important
Tracking error is not how much an ETF’s performance deviates from that of its benchmark index for a given period (that’s known as excess returns). It’s about how much those excess returns oscillate around the portfolio’s benchmark during that period.
Tracking error is measured as the standard deviation of excess returns over time. It’s an indicator of how consistently close or wide an index ETF’s performance is relative to its benchmark. For investors using indexed products, any uncertainty around performance adds uncertainty costs. Depending on an investor’s investment horizon, this uncertainty cost can be even greater than the expense ratio or trading spread.
A primary driver for investors buying an index ETF is to gain exposure to a specific slice of the market. When an ETF closely tracks its benchmark, and an investor who holds it sees that the performance they experience doesn’t deviate much from that of the benchmark, then that investor can feel confident that they’ve gained the exposure they sought.
Investors using index ETFs need to have high confidence that they’ll get their desired market exposure. Any deviation from what the market is returning can add costs. If an investor allocates to an S&P 500 ETF, she is expressing a capital market view: She thinks that the slice of the market represented by this particular ETF will do well. If the fund’s tracking error is too wide, however, she could be correct on her capital market view but not have her portfolio reflect the market’s performance.
Why tracking error is greater with bond ETFs
Many equity index fund managers seek to completely replicate their underlying index’s holdings. However, thanks to the negotiated nature of the fixed income market, it’s nearly impossible for a fixed income index fund manager to do the same.
Instead, these managers must sample or optimize their portfolios to match the index as best as they can, matching key characteristics of the index such as duration, credit quality, and yield. Because of this, fixed income index ETFs are more vulnerable to tracking error than equity index ETFs are, and there can often be larger-than-expected differences in returns between the fund and its benchmark and between products that cover the same segment of the market.
Given the distinct challenge of fixed income, conducting due diligence on fund companies is a crucial step toward ensuring that you are allocating to the product with the best chance of replicating benchmark returns.
When tracking error is a bigger issue than expense ratios
Low expense ratios are eye-catching, but if a relatively inexpensive ETF also has significant tracking error, the advantage of the low expense ratio can be eroded.
Time is also an important consideration when it comes to tracking error. In the short term, a high tracking error means higher uncertainty in performance, thus eroding the value of a tactical trade. In the long term, tracking error can be used to evaluate how consistently an index fund manager is meeting benchmark returns over time.
So, while a low expense ratio is important, a lower tracking error suggests a reduced likelihood of incurring costs from volatile performance, no matter your investment horizon.
A case study with three muni index ETFs
To illustrate why tracking error can make an outsized impact on potential returns, we compare three municipal bond index ETFs, each with holdings across the broad municipal yield curve: Vanguard Tax-Exempt Bond ETF (VTEB), iShares National Muni Bond ETF (MUB), and Schwab Municipal Bond ETF (SCMB). While their inception dates greatly differ, their monthly excess returns and tracking errors over time illustrate key differences between similar products.
The excess returns measure a straight arithmetic performance deviation over the given period. The tracking error—the more meaningful metric—shows the consistency of keeping the fund’s returns in line with its benchmark. In other words, a higher tracking error means a higher risk of being out of sync with the benchmark’s performance. (Full standardized performance data for these ETFs is at the end of this article.)
Excess returns and tracking error for three competing ETFs
Notes: VTEB seeks to track the S&P National AMT-Free Municipal Bond Index; MUB seeks to track the ICE AMT-Free US National Municipal Index; and SCMB seeks to track the ICE AMT-Free Core U.S. National Municipal Index. The three ETFs have similar investment objectives based on their prospectuses: VTEB seeks to track the performance of a benchmark index that measures the investment-grade segment of the U.S. municipal bond market; MUB seeks to track the investment results of an index composed of investment-grade U.S. municipal bonds; SCMB seeks to track as closely as possible, before fees and expenses, the total return of an index that measures the performance of the U.S. AMT-free municipal bond market. Index ETFs in the Muni National Intermediate Morningstar category—the category for each of the three ETFs shown—exclude strategic beta and sustainable-fund strategies.
Sources: Vanguard calculations, using data from Morningstar as of July 31, 2023 (excess returns range and tracking error); most recent prospectus for each ETF as of June 30, 2023 (expense ratio).
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Note: There may be other material differences between products that must be considered prior to investing.
The charts below show the oscillation of three ETFs’ excess returns over time—and also point to why tracking error is a more meaningful metric than excess returns.
Tighter tracking means lower potential losses when trading
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Notes: Bars represent an ETF’s monthly excess returns; dotted lines represent the bounds of the largest excess returns recorded during the given period; shaded areas represent the range between those bounds. Periods shown are December 31, 2019, through July 31, 2023 (for VTEB and MUB), and October 31, 2022, through July 31, 2023 (for SCMB). Excess returns for each ETF are measured against that ETF’s primary prospectus benchmark.
Sources: Vanguard calculations, using data from Morningstar as of July 31, 2023.
Each investor, of course, would have a unique entry and exit point along these timelines, and these specific points will help determine whether their investment under- or outperforms the relevant benchmark.
Even so, VTEB’s returns are distributed more narrowly around those of the relevant benchmark. At the end of any given period, ETF returns clustering tightly around benchmark returns typically results in lower tracking error.
In other words, greater volatility of excess returns translates into more uncertainty around excess returns. And—again—the tighter the tracking error, the more likely it is that you’ll avoid the cost of deviating from the market’s performance, and the easier it is to formulate thoughtful asset allocation.
SCMB only came to market in October 2022; its track record is relatively limited. Still, as these charts show, its excess returns range and its tracking error both exceed those of VTEB and MUB, thus potentially nullifying the benefit of a lower expense ratio.
This case study illustrates how something that seems as mundane as tracking error can play a crucial role in a fund’s risk and return.
Total returns for VTEB, MUB, and SCMB
The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so investors’ shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit our website at vanguard.com/performance. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Sources: Morningstar, as of August 31, 2023 (returns); recent prospectus for each ETF as of June 30, 2023 (expense ratio).
Related links:
- Tallying the total cost of owning an ETF (article, issued December 2022)
- Case studies in the cost of ETF ownership (article, issued June 2023)
- ETF premiums and discounts, explained (article, issued August 2023)
Notes:
For more information about Vanguard funds and ETFs, visit vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
Vanguard ETF Shares are not redeemable with the issuing fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
All investing is subject to risk, including the possible loss of the money you invest.
Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.
