ETFs — Tracking Difference, the Number That Beats the TER
An index fund promises the index. Tracking difference is the gap between that promise and what the fund actually paid out: the fund’s total return minus the index’s total return over the same period. It contains every cost inside the fund and every income the fund earns on top, which is why two funds on the same index with the same fee can end a quarter-point apart, and why Closelook makes it the headline number on every ETF page.
What it means
An ETF is a contract to deliver an index. The published fee says what that contract is supposed to cost; the tracking difference says what it actually cost. Closelook defines it one way and keeps to it: tracking difference = ETF total return − index total return, measured over the same period, per calendar year and annualised over one, three and five years and since the fund’s launch. A negative figure means the fund delivered less than the index, which is the real price of owning it. A positive figure means the fund delivered more than the index, because the income it earned outran the costs it carried.
Both sides of the formula are total returns. The fund side is its net asset value with every distribution reinvested, after everything that happens inside the fund. The index side is the variant the fund is contracted to track, in most UCITS funds a net-return index that already deducts the maximum withholding tax on dividends, in many US funds a gross or total-return index. The exchange price of the fund and the price version of the index have no place in the calculation; both would produce a number that is wrong by the dividend yield.
What goes into the fund side
On the cost side, everything that takes money out of the fund. The total expense ratio, which is deducted pro rata every day. The trading costs of following index changes, larger the more often the index rebalances. Withholding taxes on foreign dividends and the delay before they arrive. Swap fees in a synthetic fund. Cash drag, when distributions or new inflows sit uninvested while the market rises. Sampling error, when the fund holds fewer names than the index. And the craft of the manager, which decides how much of all this is avoided.
On the income side, everything that puts money in. Dividends and interest from the holdings, reinvested. Securities-lending revenue, which on a large, liquid fund can be worth a meaningful share of the fee. Swap income where the counterparty pays. And tax treatment better than the index assumes: a net-return index deducts the maximum withholding rate, while a fund domiciled well reclaims part of it and keeps the difference. The tracking difference is the net of both columns, which is why it is the only number that shows the true cost.
Reading the table
The examples below come from extraETF’s published tables, restated in Closelook’s sign convention, in which a positive figure means the fund beat its index. extraETF prints the same facts with the opposite sign. The iShares Core MSCI World, with a fee of 0.20% a year, has averaged a tracking difference of −0.05% a year since launch: the fund gave up five basis points to its index while charging twenty, so the manager earned back three quarters of the fee. Over the three years to August 2022, five funds on the same MSCI World index ranged from +0.21% for a fund charging 0.15% to −0.25% for a fund charging 0.50%; four of the five beat their index after fees.
The same fund can move around. The iShares STOXX Europe 600, a German-domiciled fund, beat its index by 0.38% in 2021, 0.10% in 2020 and 0.82% in 2019, lagged it by 0.19% in 2018 and beat it by 0.21% in 2017; since 2006 the average is +0.16% a year. The lesson is that one year proves little and several years prove a lot: what matters is whether the fund keeps its tracking difference in the same neighbourhood through different market phases.
Tracking error is the other number
Tracking difference is often confused with tracking error, and they answer different questions. Tracking error is the standard deviation of the fund’s daily or monthly return gap to its index, a measure of how steadily the fund follows. A fund that lags by exactly 0.20% every year has a large tracking difference and a tracking error near zero. Both belong on a fund page. Only the difference is a cost; the error is a quality reading on the replication, and it is the denominator of the information ratio when a manager is supposed to deviate.
Why the fee is not enough
The expense ratio has been the first filter for fund selection for two decades because it is printed and comparable. It is also a promise about a single cost line. The tracking difference is the outcome of all of them: a fund charging 0.50% that lags by only 0.15% has earned back 0.35%, while a fund charging 0.15% that lags by 0.30% has costs its fee does not name. The right reading is the difference over several years, with the fee beside it, on the exact index the fund tracks. Two funds on different index variants of the same market cannot be compared on this number at all.