Key Points

It is common for investors to purchase an ETF and then set it aside without further review.
As with any holding, monitoring your ETF positions remains your responsibility.
When an ETF's results diverge notably from the index it follows, a problem exists.

Exchange-traded funds have gained wide appeal due to their ease of use, broad diversification, and modest costs. Yet one concealed factor can quietly diminish your holdings by thousands over the years. This factor is known as tracking error. The following explains tracking error and outlines steps to limit its effects.

What is tracking error?

In theory an ETF should replicate the performance of its target index. For instance a fund following the S and P 500 should deliver returns close to that benchmark. Persistent differences in results signal a tracking error. Elevated error levels indicate the fund is straying from its intended path and may reduce long-term gains.

How tracking error affects your holdings

Tracking discrepancies can gradually reduce portfolio value in several ways.

Reduced compounding: Suppose the S and P 500 rises 10 percent in a year while your ETF returns only 7 percent. The three-percentage-point shortfall disappears along with any future growth it could have generated.
Expense ratios: Although many ETFs carry low fees, others impose higher management costs. Elevated fees often cause returns to fall behind the benchmark.
Tax consequences: Periodic rebalancing to stay aligned with an index can trigger capital gains distributions subject to tax. These unexpected liabilities widen the gap between benchmark performance and actual ETF results.

Steps to limit tracking error effects

Three approaches can help reduce the influence of tracking errors.

Select low-cost funds: Opt for ETFs with smaller expense ratios to improve net performance.
Spread investments: Holding several ETFs across different areas lessens the overall impact of any single tracking issue.
Review regularly: Check ETF results against the benchmark every few months. Consistent gaps point to a tracking problem that warrants attention.

ETFs serve as useful vehicles for wealth building, yet they do not always match their targets perfectly. When returns differ from the underlying index, it is time to review and adjust.