How do I select the cheapest ETF?​

How do I select the cheapest European 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?

definition of 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  • On-going Costs also known as TER (Total Expense Ratio) that has now been replaced by OCF (Ongoing Charges Figure).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 are as important as visible costs

  • Revenue from Security Lending – revenue generated by lending securities to Market Participants that want to short Equities can sometimes more than offset the losses due to Fixed Costs (OCF)
  • 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 most of the outperformance/underperformance of the ETF versus its Benchmark

Can an ETF outperform a Benchmark?

Yes, it is actually a more frequent situation than people think e.g. for some Equity ETFs where Securities Lending contributes more to the fund than all other costs combined 

In this case the ETF will outperform its Benchmark

If Tracking Difference is positive does it mean the ETF outperforms the benchmark?

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

index fund tracking difference over time

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 tracking difference example

You can use TrackInsight e.g. by taking the difference between Fund and Underlying Index under ‘Annualized historical risk/return profile’. 

On, a positive Tracking Difference is an outperformance of the ETF versus its Benchmark

#3 Use

tracking difference example

You can use  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, a negative Tracking Difference is an outperformance of the ETF versus its Benchmark

What is Tracking Error?

tracking difference - cumulative loss to benchmark model vs reality etf

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 other costs outside Tracking Difference?

As I’ve explained in more detail, you personal costs matter as well and include:

  • Taxes
  • Platform fees
  • Trading commissions

What else should I be aware of when selecting a European Index Fund?

Click on the picture above to read more about all aspects of European Index Fund Selection

Good Luck and keep’em* rolling !

(* Wheels & Dividends)

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3 months ago

Hi Raph, another cracking article with some quality content. Glad to see being mentioned as it’s such an underrated gem; I’ve also been using TrackInsight quite extensively since our last chat (thanks for that resource!). I was hoping you could help with a more ‘personalised’ query: Over the past few days, I’ve been analysing (and have been invested in) the VWRL and VWRP ETFs, however, despite being from the same provider and tracking the same index, VWRL (the distributing ETF – existed for longer) almost always outperforms VWRP (the accumulating ETF – existed <2 years), any ideas as to… Read more »

3 months ago

Hi Raph,
This is a probably a double post from my comment in your article above, but I believe this is a result of my broker’s spreads as VWRP has consistently underperformed my VWRL position despite being equally weighted AND being funded at the same time as my VWRL position.
Something for me to investigate further I suppose; Glad to see great content from yourself and it’s constantly something I refer to my mates when trying to explain concepts I can’t clearly put into words!

Thanks 😀

3 months ago

Hi Raph, this is such a great blog! I just discovered it and I wish it was a couple of months earlier… It is revealing how important the tracking difference is. I clearly haven’t chosen my ETFs in the best way according to this criterion. (Even though UCITS selection is often quite limited when one wants to invest into sth more unusal so an ETFs with a satisfactory tracking diff does not always seem available…) Also the website you suggested is really useful. For your consideration, I’d love to read more about the ESG ETFs. Long-term investing in those was… Read more »