What is Tracking Error for an ETF?

Tracking error occurs when the price of an inverse ETF deviates from the benchmark it tracks or from the value of the underlying holdings. For example, if the ABC Commodity Index was up 1% on a Friday and an ETF which tracks the index on a one-for-one basis was up 0.8% that same Friday there was a 0.2% tracking error. Note there is almost always some tracking error due to the expense ratio but with well-established and liquid underlying indices, like the S&P 500, the error is usually minimal.

Still, the average tracking error for all exchange traded funds in 2013 was 0.59%, according to a study by Morgan Stanley Smith Barney via the New York Times. Many ETFs have had this difficulty in the past and the amount of error seems to rise with leverage, increased volatility and liquidity of the underlying benchmark or index. Lee Davidson, an ETF analyst at Morningstar says the error is larger with less liquid underlying securities. This tends to include the commodities, currency and emerging market exchange traded fund space. Many indexes and benchmarks have been created recently and the derivatives tied to the more obscure ones have had some issues.

Other Inverse ETF risks include: