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?
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- On-going Costs also known as TER (Total Expense Ratio) that has now been replaced by OCF (Ongoing Charges Figure).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
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 versus its Benchmark
#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 versus its Benchmark
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 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)
My fundamental reviews of Equity ETFs and Asset Allocation include:
- Investor Checklist - Ready to Invest? Have a look at the checklist before buying ETFs
- How to build a Long Term Portfolio for Financial Independence - Guide to creating a Smart & Simple Long Term Portfolios with ETFs
- All you need to know about International ETFs - including Developed vs Emerging Markets, Small vs Mid/Large Caps and country allocations with List of Best ETFs
- The Simplest Equity Portfolio - Comparison of Best Total World Equity Index Trackers
- How to pick the perfect ETF? - Investing in Europe is not quite the same experience as in the US but this guide will solve all your issues. Spoiler - don't use TER! (applies to US Investors as well)
- Which Assets do I need in my Portfolio? - Clean up your portfolio from assets you don't need. High Performance and low maintenance Asset Allocation Strategies
- How do I benefit from a market crash? - In the long run no crash (including Japanese style) can derail you if you do it right
- How to Invest for Short Term goals? - Medium Term Investing is more risky than long term portfolio - pay attention to the right asset classes
My fundamental reviews include:
- Spectacular Market Crashes - how much can you lose? How long will it take to recover? How to take advantage of the next recession
- What if my Broker goes Bust? How to choose a Broker that is safe
- What is the best rebalancing method? How to increase returns and reduce risk by rebalancing your portfolio
- What about currency risk? Should I hedge my Portfolio? - Hedge or not to hedge? Guide to hedging currency risk in your Equity and Bond ETFs
- Should you buy Gold? - Is it necessary to have an asset that generates no yield? What really drives Gold price?
- International and European Bond ETFS - For Long Term International Investors Bonds are key to protect their Equity Portfolios
- US Bond ETF Guide - Comprehensive Review of Blend Bond Funds, Treasuries, Corporates, High Yield, Inflation Linked, Muni ETFs
- Top 3 Corporate Bond ETFs - If you want to increase income buy these ETFs to invest alongside the FED [for US Investors only]
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