| Source of tracking error | What it is | Typical magnitude |
|---|---|---|
| Expense ratio | Annual fee deducted from fund assets daily; the floor on tracking difference | 3-9 bps for broad-market US equity ETFs; 20-75 bps for sector or international |
| Sampling | Holding a representative subset of the index rather than every name -- common for indices with 1000+ holdings or illiquid tails | 5-30 bps for total-market funds; up to 100 bps for emerging-market funds |
| Optimization | Algorithmically picking names that approximate the factor exposures of the index without holding every name -- more aggressive than sampling | 10-50 bps depending on how aggressive the optimization is |
| Cash drag | Brief windows where the fund holds cash (incoming dividends, new contributions, redemption reserves) instead of being fully invested | 1-5 bps in normal markets; up to 20 bps in fast-trending markets where the fund is briefly underweight a rising market |
| Securities lending | Income the fund earns by lending out its holdings to short-sellers; reduces tracking error in the fund's favor | 1-5 bps benefit for major-index funds; up to 30 bps for funds holding hard-to-borrow small-caps |
| Rebalancing and reconstitution costs | Friction when the index drops a name and adds a new one and the fund has to trade | 1-10 bps annualized depending on how index methodology overlaps with the fund's trading desk |
Tracking error rises sharply during stress events. In March 2020, several international and bond ETFs showed 1-3% gaps to NAV intraday because the underlying baskets became hard to trade. This is not a flaw of the ETF wrapper -- it is the wrapper honestly reporting that the underlying market is broken. The right reaction is usually patience (the gap closes when liquidity returns), not panic selling at the dislocated price.
Tracking error has six common sources. For a broad-market US equity ETF you should expect tracking difference roughly equal to the expense ratio, minus 1-3 bps of securities-lending offset. For an emerging-market or specialty fund expect 30-100+ bps of structural drag from sampling and optimization. When you compare two ETFs claiming to track the same index, the tracking DIFFERENCE is the cleaner comparison than the expense ratio alone -- it captures the full picture of how the fund actually delivers index performance after all frictions.
Sit with the ideas.
An ETF promises to track the S&P 500. Last year the index returned 12.4%. The ETF returned 12.27%. The 13 basis point gap is roughly the right size for a major-index fund. Which set of sources MOST PLAUSIBLY explains it?