Ongoing charges (TER) are the best-known cost figure of an ETF. They do not tell you everything about how closely a fund actually follows its index, though. Two further figures do that and are often confused: tracking difference and tracking error.
What the TER covers – and what it does not
The TER covers the fund's ongoing management and operating costs. It does not include, among other things, transaction costs inside the fund, for example when adjusting to index changes. Conversely, a fund can earn income that does not appear in the TER, such as income from securities lending. Tax differences on dividends also affect performance.
Tracking difference (TD): the deviation in results
The tracking difference is the difference between the fund's performance and its index's performance over a given period, usually a calendar year:
TD = fund return − index return
As a rule, the fund's net asset value (with distributions reinvested) is compared with a net total return version of the index, in which dividends are reinvested after an assumed withholding tax.
- A TD of −0.15 % means the fund lagged the index by 0.15 percentage points in that period.
- A positive TD is possible, for example if the fund pays less withholding tax than the index assumes or earns securities lending income.
- The TD varies from year to year. An average over several years is more meaningful than a single year – but it is no guarantee for the future either.
A simplified, hypothetical example: fund A has a TER of 0.20 % and an average TD of −0.10 %; fund B has a TER of 0.12 % and a TD of −0.25 %. In this example fund A stayed closer to the index despite its higher TER.
Tracking error (TE): how consistent the deviation is
The tracking error is the standard deviation of the return differences between fund and index, usually calculated from daily or weekly data and annualised. It measures how consistently the fund follows the index – not how far it lags in the end.
- A fund can have a very low tracking error and still lag the index by a steady amount every year.
- A higher tracking error is not automatically a sign of poor management. It can result from sampling (the fund holds only a selection of the index constituents), markets with less liquid securities, different valuation times or the timing of dividend payments.
Where to find the figures
Under the ESMA guidelines on ETFs and other UCITS issues (ESMA/2014/937), index-tracking UCITS must state, among other things, the realised tracking error and the annual tracking difference in their annual report and explain deviations from the anticipated tracking error. Many issuers also show the figures in their factsheets.
On indexfonds.eu we show tracking difference and tracking error only when a comparable total return series for the index is available in the same currency. A comparison with a price index without dividends or with an ETF used as a proxy would mainly measure dividends, currency effects or the proxy's costs.
Points to consider
- Do not confuse TER, tracking difference and tracking error.
- Look at the tracking difference over several years and compare only funds on the same index.
- Check which index variant (price, net or gross return) is used as the benchmark.
- Consider your own trading costs (spread, order fees) as well as the fund's costs.
Past tracking figures describe the past. Cost structures, tax rules and securities lending can change.