ETF tracking error, discounts and premiums

The long term variance between an ETF's performance and that of its underlying index is called 'tracking error.'  Short term variations between an ETF's price and Net Asset Value (actual value of its underlying securities) are called 'premiums' and 'discounts.'

  • Tracking error causes: ETFs do experience tracking error, because: 1) Every fund has an annual fee, which by definition detracts from its total performance compared to the index; and 2) For a number of reasons, a given ETF may not hold every single security in its underlying index in exact proportion to its weight in that index, thereby generating tracking error.
  • Tracking error averages: A recent Morgan Stanley report said that tracking error in 2006 averaged 0.29% for U.S. major-market ETFs, 0.33% for U.S. "style" ETFs, 0.61% for U.S. sector and industry funds, 0.72% for international portfolios, and 0.09% for fixed-income ETFs.
  • Premiums and discounts to NAV: An ETF's share price at any moment can vary slightly from its NAV because ETF prices are determined by supply and demand on the open market. However, ETF prices generally stay very close to their NAVs, which are updated every 15 seconds, because market makers are authorized to create and redeem ETF shares (see how ETFs work). If an ETF's price gets out of line with its NAV, these firms can quickly step in to buy or sell, thereby closing the gap.
  • Special premium/discount situations: In some situations, such as the market decline of February 27, 2007, ETF prices have gotten temporarily out of whack with their NAVs. This happened: 1) when the prices of underlying assets such as precious metals weren't updated as quickly as the ETF prices; and 2) when volatility created uncertainty about the value of ETFs tracking international indexes whose holdings were traded on foreign exchanges closed while U.S. markets were open. In both cases, prices and NAVs ultimately came back into line, but investors who bought or sold that day got a discount or paid a premium.
  • Related reading: "Small Investors Beware - Fast Money Crowd Embraces ETFs." Wall Street Journal (subscription required), 03-17-07. A good in-depth look at ETF discounts and premiums during the market decline of February 27th, 2007.