On the surface, ETFs — exchange-traded funds — managed by competing firms that track the same underlying index appear to deliver a standardized product. A new report that looks under the hood suggests otherwise.
In a 2024 Dimensional Fund Advisors report, the average annual return difference among four U.S. total market indexes over the past 20 years ranged from 0.2% to 3.2%, with an average spread of 1%.
Still, despite their seeming uniformity, there is no consistent approach to defining or tracking a market. Seemingly minor differences could have profound significance over the long term.
Many Main Street investors take a simple approach to investing. They buy passive ETFs, often through monthly dollar cost-averaging, to grow with the market gradually.
This strategy is all well and good, but not all ETFs track the same way. Some funds could quietly underperform for decades.
The gap between targeted stocks, their equivalent indexes, and the tracking fund can result in a more active than passive strategy, leaving precious pennies on the table — a sin for savvy investors.
By being aware of discrepancies and informing their strategy, investors can course correct and select funds that track more accurately or outperform their benchmarks.
Financial advisors share how they “mind the gap,” drawing on their advice to clients.
Active or Passive?
Broad-based ETFs appear almost identical, but looks can be deceptive. The annual returns of funds that track the same indexes can be as much as 3% apart. Take Tesla.
In January 2020, Elon Musk’s vehicle firm traded at around $100 per share, making it the 60th-largest company in the U.S. by capitalization. But because it hadn’t met all S&P 500 index eligibility criteria — like four consecutive quarters of positive earnings — it still hadn’t joined the index.
There is already some daylight between the index and its ideal concept (for instance, the largest 500 companies in the U.S.). However, there are additional layers of potential error. Investors don’t buy the index itself, but a fund, managed, for instance, by BlackRock or Fidelity, that tries to track the index, which is a perpetually moving target.
“While index funds aim to replicate the performance of a particular market index, differences in index construction, weighting methodologies, and rebalancing frequencies can lead to performance disparities,” says Arielle Tucker, Founder of Connected Financial Planning.
Selecting an ETF involves more than choosing a market segment; it requires analyzing how the fund tracks its index and ensuring investments align with one’s financial goals and risk tolerance.
Many investors pick ETFs based on their management fees, or “expense ratio.” However, Tucker advises her clients to assess ETFs across additional metrics like Tracking Error, Liquidity, Index Methodology, and Tax Efficiency.
“The thing to remember is ETFs are managed by humans,” explains Lakehouse Family Wealth Founder Benjamin Simerly. “This means that every human is going to manage an ETF or index just a little bit differently than the next.”
“The next thing to remember is that this news isn’t necessarily bad,” Simerly adds. “Like any other area of life, there will always be good, bad, and in-between ETFs.”
What’s Your Flavor?
The ETF wrapper gained popularity in the 1980s, largely thanks to Vanguard founder Jack Bogle, who championed the simplicity and cost-effectiveness of buying the market rather than attempting to beat it.
This strategy undergirded the first-ever ETF — SPDR S&P 500 ETF (SPY) — and exposed investors to the whole S&P 500 in one easy buy.
Since those early years, the evolving ETF product category has taken on a life of its own. According to a recent Financial Times report, ETFs have proliferated wildly by type and scope.
“ETFs are becoming like ice cream at your local boutique creamery,” says Simmerly. “Sure, you’ll find Chocolate and Vanilla, but you’ll also find ‘Roasted Jalapeno Chocolate with Madagascar Cinnamon.'”
These include highly leveraged indexed products. Asset volume of U.S. options-based ETFs surged past $100 billion, skyrocketing 600% over the past three years, according to JPMorgan. Most traded options are puts, suggesting many use these as downside hedges to put a floor under a portfolio.
Seismic growth in the active ETF space — actively managed funds versus those passively tracked — suggests that more investors see ETFs as a way to pursue active and passive strategies. JPMorgan estimates active ETFs have accounted for over 60% of all U.S. ETF launches every year since 2020.
So, while the overall trend toward passive strategies remains, investors increasingly choose ETFs over mutual funds as their preferred vehicle.
According to Dimensional, index fund managers are typically judged by how closely they track their target indexes. However, prioritizing tracking errors above all can leave returns on the table as managers forgo the flexibility and discretion driving more efficient trade execution.
Jason Gilbert, founder and managing partner at RGA Investment Advisors LLC, agrees this is a serious issue for the industry. “This is something I’ve thought about often. If an ETF manager is only focused on minimizing tracking error, they may miss out on opportunistic trading that could benefit investors.”
“This is where some ETFs can operate almost like quasi-active funds — by allowing a little more discretion in execution, they can optimize returns,” says Gilbert. “So, while tracking is important, I agree that it shouldn’t come at the expense of flexibility and execution efficiency. This is why I’m selective about which ETFs I recommend, ensuring that the strategy aligns with the investor’s objectives and isn’t too rigid.”
“Honestly, it doesn’t matter if the ETF tracks an index closely or not,” adds Simmerly. “What truly matters is whether or not that ETF and how it trades are a fit for you and your portfolio. All ETFs are at least a little different, even if they claim to do the same thing. They all have their own peculiarities and differences in performance bear this out. The key is finding the ETF that has peculiarities that are a fit for you.”
While straightforward, EFTs’ tracking methods and management nuances can significantly impact performance. Understanding these differences becomes increasingly crucial for investors as the market evolves.
By assessing each ETF’s unique characteristics and aligning them with personal goals, investors can guard against tripping up on tracking gaps. Staying informed and working with experienced financial advisors empowers investors to navigate investing more effectively, ensuring they select funds that meet their needs.
