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Updated 2mo ago.
Updated 2mo ago.
Tracking error measures the gap between an ETF's performance and that of the index it seeks to replicate. It is generally expressed as the annualized standard deviation of the return differences. A low tracking error indicates the ETF faithfully replicates its benchmark index.
VFV.TO tracks the S&P 500. If the S&P 500 gains 10.0% in a year and VFV.TO gains 9.75%, the tracking difference is -0.25%. The annualized tracking error over several years for large ETFs like VFV.TO or ZSP.TO is typically 0.05 to 0.15%. Smaller ETFs or those on illiquid markets can have tracking errors of 0.5% or more.
An ETF can have a low MER but a high tracking error (due to internal transaction costs, suboptimal securities lending, etc.), making its true total cost higher than the stated MER. Ideally, compare the tracking difference (1-year return gap) rather than the statistical tracking error to assess an ETF's actual efficiency.