Two exchange-traded funds (ETFs) tracking the same index may not deliver identical returns. Differences in expenses, portfolio management and trading prices can affect how closely each fund follows its benchmark, and how much investors ultimately earn.
An index represents a benchmark, while an ETF holds securities to replicate its performance.
The fund incurs operating and transaction costs, and its units trade on stock exchanges at market prices that may differ from the value of their underlying holdings.
Here are the key factors investors should examine when comparing ETFs tracking the same index.
Tracking difference: How much did the ETF lag its index?
Tracking difference measures the gap between an ETF’s return and its benchmark over a specified period. It reflects the extent to which the fund has underperformed or outperformed the index.
For example, an investment of ₹10 lakh growing at 12% annually for 10 years would reach approximately ₹31.06 lakh. At 11.65%, it would grow to around ₹30.10 lakh — a difference of nearly ₹96,000. This is an illustrative calculation assuming constant annual returns.
Ashok Suvarna, CEO of Aditya Birla Money, advises investors to compare tracking difference across different market conditions rather than relying on returns for a single period. A sustained gap can have a greater impact on long-term returns than a comparison of recent performance suggests.
Tracking error: How stable is the gap?
Tracking error measures the variability of the difference between an ETF’s returns and those of its benchmark. Unlike tracking difference, it does not indicate the overall size of the fund’s underperformance.
An ETF may consistently trail its index by a small amount and have low tracking error. Another may experience more variable deviations. Investors should therefore examine both measures when assessing how efficiently a fund replicates its benchmark.
Why a lower expense ratio may not be enough
The expense ratio captures an ETF’s annual operating expenses, but it does not account for every factor affecting returns. Cash holdings, dividend timing and the costs of rebalancing the portfolio can also contribute to differences in performance.
Ajay Saraf, executive director at ICICI Securities, recommends comparing expense ratios alongside tracking performance, the premium or discount to indicative net asset value (iNAV), and the fund’s size and liquidity.
The expense ratio is therefore an important starting point, rather than the sole basis for choosing between otherwise similar ETFs.
Market price and liquidity: What investors pay to trade
ETF units trade on exchanges, which means the price investors pay can differ from the net asset value (NAV) of the underlying portfolio.
For instance, if an ETF’s indicative value is ₹100 but it trades at ₹101, a buyer pays a 1% premium. If that premium subsequently disappears, the investor’s return may suffer even if the underlying portfolio’s value remains unchanged.
The bid-ask spread is another cost to consider. If an ETF has a bid price of ₹100 and an ask price of ₹100.20, an investor buying at the ask and immediately selling at the bid would incur a 0.2% spread-related cost, excluding brokerage and other charges.
Prashant Gupta, chief business officer at SAMCO Wealth, highlights this distinction between the return generated by an ETF’s portfolio and the return realised by the investor after trading costs. A fund’s performance relative to its index does not, by itself, capture the price at which an investor buys or sells its units.
What should investors compare?
Before choosing between ETFs tracking the same index, investors should check:
- Tracking difference: Compare the gap against the same benchmark over multiple periods.
- Tracking error: Assess how consistently the fund follows the index.
- Expense ratio: Compare annual operating costs.
- Bid-ask spread and iNAV: Evaluate trading costs and whether the market price is at a significant premium or discount.
- Fund size and liquidity: Consider AUM alongside actual trading activity and spreads.
For long-term investors, persistent tracking difference and recurring costs deserve particular attention. Investors who trade frequently should also consider spreads and execution prices.