Two 'Index' Funds Can Track the Same Index and Still Give You Different Returns. Tracking Error Is the Number That Explains the Gap
6 min read
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6 min read
Two ETFs can both promise to track the S&P 500. You check their one-year returns and they are not identical. Neither one is broken and neither one is lying. Every fund that tracks an index drifts from it by some small amount, and tracking error is the number built to measure exactly how much.
Tracking error is the standard deviation of the gap between a fund's return and its benchmark index's return, measured over many periods and annualized. It answers a narrow, useful question: not "did the fund beat or lag the index," but "how consistent is the size of that gap from one period to the next."
Tracking error = standard deviation of (Fund return − Benchmark return)
A fund that trails its index by close to the same small amount every single period has a low tracking error, even if it never quite catches up. A fund whose gap swings from ahead of the index one quarter to behind it the next, even by similar average amounts, has a higher tracking error. The average size of the gap and how erratic that gap is are two different questions, which is exactly where most explanations of this number go wrong.
Financial writers use these two terms almost interchangeably, and Morningstar's own research on ETF tracking has flagged this as a common source of confusion. Tracking difference is the actual return gap over a specific period. A fund that returned 9.4% while its index returned 10.0% for the year has a -0.6% tracking difference for that year. Tracking error is the standard deviation of that gap measured across many periods. A fund can have a small average tracking difference and still carry a larger tracking error, if the size of the gap bounces around a lot from period to period rather than sitting still.
In practice: tracking difference tells you how much a fund has actually cost or gained you so far. Tracking error tells you how much you should trust that number to repeat, or how surprised you might be next period.
SPY and VOO, the SPDR S&P 500 ETF Trust and the Vanguard S&P 500 ETF, both track the S&P 500 and both hold essentially the same stocks in essentially the same weights. Reported holdings counts differ slightly, 503 for SPY against 518 for VOO, but that gap comes from how each fund counts a company's dual-class shares, not from a real difference in what each fund owns.
What differs is cost. SPY charges a 0.0945% annual expense ratio. VOO charges 0.03%, about a third of SPY's cost. That 0.0645 percentage-point gap is deducted from each fund's return every single year, which means it is also the single biggest predictable driver of the tracking difference between them.
Isolate just that fee gap, holding everything else equal, and compound it over ten years: VOO would retain about 99.70% of an identical gross return, SPY about 99.06%. The difference is roughly 0.64 percentage points cumulatively, about $640 on a $100,000 position, purely from the expense ratio, before counting anything else. VOO also reinvests dividends automatically inside the fund, while SPY distributes dividends as cash that sits briefly uninvested before an investor redeploys it, a second, smaller drag on SPY's side sometimes called cash drag.
Fees are the steadiest driver, since they apply the same way every single day and therefore usually show up more in tracking difference than in tracking error itself. Tracking error tends to come from less predictable sources:
Sampling instead of full replication. A fund that buys every single stock in its index in the exact index weight, the way both SPY and VOO do for the S&P 500, tends to track tightly. A fund that instead buys a representative sample, common for indices with hundreds or thousands of thinly-traded constituents, introduces a source of drift that fees alone don't explain.
Cash drag. Dividends received but not yet reinvested, and cash held to meet daily redemptions, sit outside the market for a short window and can pull a fund's return away from the fully-invested index.
Trading and rebalancing costs. Every time an index adds or removes a constituent, or an index-tracking fund rebalances to match new weights, the trades themselves cost money the index's own calculation does not pay.
Currency and liquidity effects, for a fund tracking a foreign or less liquid index than the market it actually trades in.
There is no single number that applies to every fund, because how hard an index is to replicate depends heavily on what it holds. For large, liquid, easily-replicated benchmarks like the S&P 500, well-run funds typically run below roughly 0.20% tracking error, with the tightest funds closer to 0.05% to 0.15%. Indices built from smaller, thinner-traded or harder-to-source constituents, mid-cap, small-cap or less liquid benchmarks among them, more commonly run 0.25% to 0.50% or higher, and some markets treat figures as high as 1% as a normal range for that kind of index. A single reading also tells you less than a consistent one: a fund whose tracking error stays low and stable across several years is doing its job better than one with the same average reading that swings widely from year to year.
Comparing two funds that track the same benchmark starts with reading both funds' factsheets for their published expense ratio, since fees are the most predictable piece of any tracking gap and the easiest one to check before you buy. From there, a fund's actual multi-year return against its stated benchmark, not just its fee, is what tells you whether the rest of the tracking gap has stayed small and steady.
Explore NetWort's own screener to filter down to ETFs or indices, and compare a fund's 3-year return next to the index it tracks side by side. A fund that has quietly drifted further from its benchmark than its expense ratio alone would explain is worth a second look before you add to it, whichever benchmark or fund pair you are checking.