ETF tracking difference and total cost

An exchange traded fund that follows an index is trying to reproduce a number, and it never reproduces it exactly. The gap between the fund's return over a period and the index's return over the same period is the tracking difference. It is measured after the fact and stated as a percentage, and it can fall on either side of zero, although the costs pushing it one way are structural and the effects pushing it the other are not.

It is routinely confused with the expense ratio, which is a different thing measured differently. The expense ratio is the management fee the fund charges, disclosed in advance as an annual percentage. Tracking difference is the total observed gap, which includes the expense ratio and everything else. The second is the number that describes what holding the fund actually delivered.

The four sources of the gap 

The management fee is the first and the only one disclosed in advance. It is accrued daily out of the fund's assets, so it reduces the fund's value continuously rather than being charged to holders separately.

Transaction costs are the second. An index is a calculation and can change its constituents without cost. A fund holding the constituents has to buy and sell real securities to follow those changes, crossing spreads and paying commissions each time. An index that reconstitutes frequently, or that holds less liquid securities, imposes more of this cost on any fund following it.

Cash drag is the third. Dividends received from the underlying holdings sit as cash until they are reinvested, and cash does not participate in a rising market. A fund holding a portfolio that pays substantial dividends therefore lags a total return index slightly, purely from the timing of reinvestment.

Securities lending is the fourth, and it is the one that pushes in the other direction. A fund that lends out its holdings to short sellers earns a fee, and where that revenue is returned to the fund it offsets some of the costs above. This is why a small number of funds have historically tracked their index with a difference close to zero or occasionally favourable, despite charging a fee.

How the gap accumulates 

The last row is the point of the exercise. The observed gap and the stated fee are close in this construction but they are not the same number, and there is no fixed relationship between them. A fund with a higher fee and strong lending revenue can track more closely than one with a lower fee and none, which is why comparing funds on the fee alone answers a narrower question than it appears to.

A related measure, tracking error, is frequently used as though it meant the same thing. Tracking difference is the gap in the return. Tracking error is the volatility of that gap, meaning how consistently the fund lags or leads rather than by how much. A fund can have a large difference and a small error, lagging by a predictable amount, or the reverse.

How the fund is constructed 

A fund holding every constituent in its index weights has the smallest structural source of difference and the highest transaction costs, since it must hold illiquid constituents at their index weight. A fund holding a representative sample has lower transaction costs and a source of difference the first does not have, because the sample and the index are not identical.

A synthetic fund holds a swap contract with a bank that pays the index return, which can track extremely closely because the tracking is contractual. In exchange it introduces an exposure to the bank on the other side of that contract. The trade off is between tracking precision and counterparty exposure, and it is a genuine trade off rather than a case of one structure being better.

Two categories behave differently again and are frequently misread. A leveraged fund targets a multiple of its index's DAILY return and resets each day, so its return over any longer period is not that multiple of the index's return over the period. An inverse fund does the same with a negative multiple. Both are constructed for a single day and are not designed to track over longer horizons, and the divergence grows with the volatility of the index rather than with time alone.

The contract layer on top 

A contract for difference written on an exchange traded fund inherits everything above and adds its own costs. The fund's internal costs are already inside the price the contract references, so they are carried without appearing anywhere on a statement. On top of them the contract carries the spread on the fund's own quote, any commission, and a financing adjustment for every night the position is held.

The result is two cost layers with different characters. The fund's costs are a small annual percentage embedded in the price. The contract's financing is a nightly amount on the full notional value, which is a different order of magnitude and accrues regardless of whether the position is ahead or behind. Over a short holding period the second is small; over a long one it dominates, and it is the reason a contract on a fund and a holding in the fund diverge the longer they are compared.

Dividends reach the contract through the same route as any other share contract. A fund distributing income goes ex dividend like any listed security, its price drops accordingly, and the contract carries a cash adjustment. Accumulating funds that reinvest internally do not distribute, so no adjustment arises and the reinvestment is already inside the price.