Tracking error is the standard deviation or volatility of the difference between the performance of an ETF and its benchmark index returns. The causes of tracking error include:
1. Benchmark indices are not subject to deductions for fees, such as management fees, which are borne by the ETF.
2. There are no fees associated with index-adjusted constituents, and ETFs incur transaction costs to adjust constituents.
3. When an index adjusts its constituent stocks, there is no trading aspect, but the ETF has to actually buy or sell the securities. If there is a rapid change in the constituents of an index, such as a sharp rise, fall, suspension of trading or the prohibition of short selling, etc., the ETF may not be able to adjust the constituents in real time in accordance with its operational strategy, which will result in greater variation between the constituents of the ETF and the constituents of the index, and hence greater tracking error.