How do I select the cheapest ETF?
How do I choose between two ETFs, purely based on costs?
- ETF #1 has a Tracking Difference of +0.21% and a Tracking Error of +0.09%
- ETF #2 has a Tracking Difference of -0.18% and Tracking Error of +0.25%
Assuming ETF #1 and ETF #2 Track the same underlying Index, have the same currencies and dividend distribution policies which ETF has a lower cost and better performance?
Causes of Tracking Difference
Cost is the key source of Tracking Error (TE) and Tracking Difference (TD).
While holding an ETF you incur two types of costs:
- Fixed Costs (OCF / TER) and
- Variable elements (e.g. bid / ask spreads)
What is Tracking Difference?
Tracking Difference takes into account all visible and invisible costs of an ETF
Visible costs include:
- Management Expenses (MER)
- On-going Costs also known as TER (Total Expense Ratio) that has now been replaced by OCF (Ongoing Charges Figure). Note that Management expenses are included in TER/OCF
Invisible Costs include:
Invisible costs (and revenues) can be more important than visible costs
- Revenues from Security Lending – revenues generated by lending securities to Market Participants that want to short Equities can sometimes more than offset the losses due to Fixed Costs (OCF)
- Different Tax treatment – Benchmarks usually apply maximum Withholding tax on dividends e.g. 30% for US, while some UCITS ETF may benefit from double tax treaties (e.g. 15% for ETFs domiciled in Ireland and investing in US Securities). However, if you compare two Irish domiciled ETFs both will have the same advantage vs. benchmark and Tracking Difference comparison between them is still relevant
- ETFs using sampling techniques to replicate benchmark usually have greater tracking error and difference compared to fully replicating ETFs since constituents do not exactly match the benchmark
- Rebalancing Costs – any variable costs incurred during rebalancing process
Is Tracking Difference Important?
Yes, Tracking Difference will explain the outperformance/underperformance of the ETF versus its Benchmark
Can an ETF outperform a Benchmark?
Yes, it is actually a more frequent situation than Investors think e.g. for some Equity ETFs where Securities Lending contributes more to the fund than all other costs combined (it could be the case for markets that are frequently shorted)
In this case the ETF may outperform its Benchmark.
However, it is always important to account for the difference in tax treatment (ETF benchmarks may be more punitive e.g. Net Total Return Indices).
If Tracking Difference is positive does it mean the outperformance is higher?
There are at least three ways for European Index Investors to check Tracking Difference
Each method has its own pro and cons and may not be entirely consistent depending on the data being used. My preference hierarchy is as described below:
#1 Your own analysis
The most reliable (albeit time-consuming) method is to have underlying benchmark data and ETF performance data and compare it. Accessing the data to perform the analysis may not be straightforward, though.
Whether it’s positive or negative depends entirely on the way you subtract (ETF – Benchmark or opposite)
I have explained the way to perform this analysis here
#2 Use TrackInsight.com
You can use TrackInsight e.g. by taking the difference between Fund and Underlying Index under ‘Annualized historical risk/return profile’.
On TrackInsight.com, a positive Tracking Difference is an outperformance of the ETF. You can compare two ETFs on a relative basis vs. the benchmark. The higher the TD the better the performance of the Fund.
#3 Use TrackingDifferences.com
You can use TrackingDifferences.com by taking the difference between Fund and Underlying Index under ‘TD’ Column
As you can see the comparison between European Index Funds is not consistent (some have longer track records, and in each case the full record is used for comparison purposes)
The website is in German but Google Translate can help
On TrackingDifferences.com, a negative Tracking Difference is an outperformance of the ETF. You can compare two ETFs on a relative basis vs. the benchmark. The lower the TD the better the performance of the Fund.
What is Tracking Error?
ETFs total costs (as represented by Tracking Difference) are not the only aspect when selecting an ETF.
If the total cost is e.g. 0.24% per annum (as illustrated above) this cost can be incurred in a linear way (good tracking error) or be more random over time (due e.g. to changing nature of invisible costs)
The orange line represents a smooth cost whereas the red line is what happens in reality
You can read more about how it works here
Is Tracking Error Important?
If you primary goal is the long term performance of the ETF I’d focus on Tracking Difference but if you are buying and selling ETFs frequently you may also have a look at Tracking Error as well
Are there any cases when I should also look at TER rather than Tracking Difference?
Two exceptions to the rule
Generally, Tracking Difference is vastly superior way of comparing ETFs vs. TER, because it takes into account hidden costs and revenues. But there are two cases when you should be careful taking long term Tracking Differences at face value.
In these cases, you may also take into account the TER or shorten the period when you look at TDs.
#1 Recent change in TER
If an ETF has recently substantially lowered its TER, future performance may be better than Tracking Difference may imply.
As a broad guidance you can take the difference in TER and add it to Tracking Difference to understand how the ETF may have behaved if it always used its recent, lower TER.
This is the case for iShares MSCI ACWI UCITS ETFs, that dropped on-going fees from 0.6% to 0.2%, as I’ve explained in an analysis dedicated to Global ETFs.
#2 Certain Currency Hedged Bond ETFs
When analyzing a number of Bond ETFs and comparing them with my own data I have seen substantial Tracking Differences.
Why is it the case? Some Bond ETFs’ stated benchmarks (per documentation) are unhedged, while in realite they are hedged so returns diverge.
I went around the issue by doing my own analysis taking hedged benchmarks but be careful taking third party TDs at face value in such case. It may be more sensible to rely on TERs.
Are there any other costs outside Tracking Difference?
What else should I be aware of when selecting a European Index Fund?
Good Luck and keep’em* rolling !
(* Wheels & Dividends)
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