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Tom Lydon, ETF Trends (179 clicks)
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When it comes to trading exchange traded funds, costs matter. Looking beyond explicit costs, such as commission fees and the expense ratio, people should be aware of the implicit costs as well.

For example, investors should be mindful of how closely an ETF actually tracks its underlying index, writes Jason Kephart for InvestmentNews.

"We think it's a good measure of how the portfolio is managed and gives an indication of how much misfit risk you're taking, relative to the underlying portfolio," Joel Dickson, a senior investment strategist in The Vanguard Group Inc.'s Investment Strategy Group, said in the article.

In a perfect world, investors would assume that a passive ETF would reflect the returns of its underlying index, sans the expense ratio. However, this is not always how it plays out.

According to Morgan Stanley, the average ETF had a tracking error - the divergence between the ETF's performance to that of the underlying index - of 0.59% in 2012, up from 0.52% in 2011. Additionally, only 39% of ETFs had a tracking error less than their expense ratio in 2012, down from 53% in 2011.

The firm found that the average tracking error and the magnitude has been ticking higher as the ETF universe expands into more-exotic investments.

Industry experts attribute tracking error to how ETFs are constructed, or "optimizing." Rene Casis, director in the iShares Index Equity Portfolio Management Group, explained that ETFs employ a type of sampling technique that only picks certain stocks from an index. He argues that fully replicating an index is not always practical, especially in less liquid markets and hard to access areas, such as the emerging markets.

However, some fund sponsors have also tried to mitigate the effects of tracking errors through securities lending by loaning out underlying shares to borrowers for a profit, which could even help an ETF outperform its expense ratio.

Max Chen contributed to this article.

Source: How Tracking Error Can Impact ETF Performance