Pay Attention to Tracking Error

When buying index funds that cover smaller slices of the market, watch out for the difference between a fund’s performance and the index that the fund is supposed to track.

The performance-index gap isn’t a problem for ETFs tied to broad-market benchmarks according to Sam Mamudi in the article Not All Index Funds Are Built Alike.  However, exchange traded funds that track more volatile sectors can experience tracking error.

For example, Mamudi points out that the iShares MSCI Emerging Markets Index ETF (EEM) and the Vanguard Emerging Markets ETF (VWO) are both linked to the same benchmark — the MSCI Emerging Markets Index — yet delivered different results in 2009 when the Vanguard fund outperformed the iShares fund.

Turns out that Vanguard has a trading advantage because it pools ETF assets with mutual fund assets.  Another example where Vanguard has an edge – the Vanguard Total Bond Market ETF (BND).

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