Do ETFs have tracking error risk? How does it arise?

Tracking error refers to the volatility of return differences between an ETF and its benchmark index. ETFs do carry tracking error risk, mainly caused by:

• Fee and expense differences

The benchmark index itself incurs no fees, but ETFs bear ongoing costs such as management fees and custody fees, which directly affect net asset value and create tracking differences.

• Transaction costs from constituent rebalancing

Index rebalancing does not involve trading costs, but ETFs must execute actual purchases and sales to adjust holdings, incurring transaction costs that cause performance deviation.

• Practical trading limitations

Index rebalancing is theoretical and does not consider market constraints. ETFs, however, must trade actual securities.

During rebalancing, if underlying stocks surge, plunge, are suspended, or subject to short-selling bans, the ETF may fail to adjust holdings in a timely manner. This widens the gap between the ETF’s holdings and the index composition, increasing tracking error.