Tracking error has 5 main causes: (1) OCF drag — the management fee eats into returns, (2) sampling vs full replication — some ETFs hold a representative sample rather than every stock in the index, (3) dividend timing — index assumes immediate reinvestment, ETF reinvests on a schedule, (4) currency effects — comparing GBP-denominated ETF to USD-denominated index, (5) securities lending revenue — actually REDUCES tracking error for many ETFs. Most tracking error of 0.05-0.20% per year is normal. Tracking error consistently above 0.30%/year is worth investigating.
Cause 1 — OCF drag (the main culprit)
The Ongoing Charges Figure (OCF) is the annual cost of the ETF. For a 0.07% OCF S&P 500 tracker, you'd expect to underperform the S&P 500 by approximately 0.07% per year — this is the management fee.
If the index returns 10%, your ETF returns approximately 9.93%. Over 30 years at 0.07% drag, this becomes a 2-3% drag on final portfolio value.
Worth doing: for two trackers of the same index, compare OCFs. The lower-OCF option will have lower tracking error.
Cause 2 — Sampling vs full replication
For broad indices like S&P 500 (500 stocks), most ETFs use full replication — holding every stock in proportion to the index. Tracking error is minimal.
For very wide indices like MSCI All-Country World (~3,000 stocks) or Russell 2000 (~2,000 small-caps), some ETFs use sampling — holding a representative subset (often 70-90% of stocks). This reduces costs but adds tracking error of 0.10-0.30% per year.
Worth checking: look at the ETF's annual report. If it uses "optimised" or "stratified sampling", expect slightly higher tracking error than a full-replication equivalent. For very broad indices, sampling is unavoidable.
Cause 3 — Dividend timing
The index assumes dividends are reinvested at the moment they're declared. The ETF reinvests on a schedule — quarterly or semi-annually. This creates timing mismatches.
If the market rises sharply after a dividend declaration but before reinvestment, the ETF lags. If the market falls, the ETF outperforms slightly.
Tracking error from dividend timing is typically 0.02-0.05% per year — small but real. Accumulating ETFs typically have slightly lower tracking error than distributing because reinvestment is more efficient.
Cause 4 — Currency effects
This causes the most confusion. If you compare a Sterling-denominated S&P 500 ETF (e.g. VUSA on LSE) to the S&P 500 index (USD-denominated), the comparison is misleading.
- S&P 500 index returns are in USD.
- VUSA returns are in GBP.
- If GBP/USD strengthens 5% during a year when the index returns 10% in USD, VUSA returns approximately 5% in GBP (the USD gain is offset by GBP appreciation).
This isn't tracking error — it's a different unit of measure. Compare like-for-like: GBP-denominated ETF to GBP-converted index return.
Cause 5 — Securities lending revenue (counter-intuitively reduces tracking error)
Many ETFs lend their holdings to short-sellers, earning a small fee. This revenue offsets the ETF's costs and reduces tracking error — often by 0.02-0.05% per year.
You'll see "securities lending" in the ETF's annual report. Most major ETFs (Vanguard, iShares) engage in this and disclose the revenue.
Concerns about securities lending counterparty risk are typically minor — collateral requirements (often 105%+ of the value of lent securities) protect against borrower default. But it does mean the ETF is taking some operational risk for the benefit of lower OCF drag.
The diagnostic — when is tracking error concerning?
| Annual tracking error | Likely cause | Action |
|---|---|---|
| 0.00–0.10% | OCF drag only — expected | Normal. No action. |
| 0.10–0.20% | OCF + sampling on broad indices | Normal for broad-market ETFs. |
| 0.20–0.30% | OCF + sampling + dividend timing | Acceptable. Check the ETF factsheet for explanation. |
| 0.30–0.50% | Concerning. Check methodology, sampling, or unusual derivative usage. | Compare to peer ETFs on same index. Switch if better available. |
| 0.50%+ persistent | Probably wrong fund choice or specific operational issue | Switch ETFs. |
Worked example — comparing two S&P 500 trackers
VUSA (Vanguard) vs SXR8 (iShares Core)
Both track S&P 500. Both are Irish-domiciled UCITS. Both are accumulating.
| VUSA OCF: 0.07% | Expected tracking error ~0.07% |
| SXR8 OCF: 0.07% | Expected tracking error ~0.07% |
| Index return 2024 (S&P 500 GBP-adjusted) | +22.4% |
| VUSA actual return 2024 | +22.30% |
| SXR8 actual return 2024 | +22.28% |
| VUSA tracking error | −0.10% |
| SXR8 tracking error | −0.12% |
Both within expected range. Difference between VUSA and SXR8 is negligible. Choose either based on platform availability and bid-ask spread.
How to actually measure tracking error
- Find the ETF's most recent annual report (KIID document).
- Look for "tracking error" or "tracking difference" stat — usually expressed as % per year.
- Compare to peer ETFs tracking the same index.
- Long-term tracking error matters most. Don't over-react to 1-quarter or 1-year variations.
What's NOT tracking error
- Comparing index price to ETF NAV at different times. Use end-of-day matching.
- Comparing distributing ETF NAV to total-return index. Add back distributed dividends for fair comparison.
- Cross-currency comparison. Either GBP-denominated ETF vs GBP-adjusted index, OR USD-denominated ETF vs USD index. Don't cross.
- Looking at just one year. Use rolling 3-year tracking error for stable assessment.
Sources and methodology
Tracking error mechanics follow standard fund management theory. ETF factsheets and annual reports are the authoritative source for each ETF's tracking error. For a personalised ETF selection process, see the tax adviser editorial recommendation (regulated investment advice requires FCA authorisation). The methodology page documents sources.
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