Learn How Vanguard Seeks to Cut the Cost of Index Tracking Error

Assessing total cost of ownership and the impact of index tracking error on ETF investments


While most investors have been doing due diligence on active strategies for decades, we’re hearing from more and more investors looking for guidance on how best to evaluate performance when they have a mandate to use index funds. In previous articles, we’ve explored how ETF investors should consider expense ratio, trading spreads, and premium/discount volatility in the total cost of ownership (TCO) framework.  

Here, we’ll turn to index tracking error and how it can affect total cost of ownership. Tracking error is a variable that’s easy to overlook, but one that’s at the center of using index funds. You may not think of it as an expense, but to the extent that it impacts the investment returns you walk away with, tracking error can certainly result in a cost.

As the disclosures say: “Indexes are unmanaged and cannot be invested in directly.” Any fund manager offering index ETFs must deal with frictions and challenges that, if not handled well, can lead to performance differences from the pure index. These involve transaction costs, sampling differences, timing of cash flows, and differences in local-market timing schedules. Asset managers who offer index products are constantly improving and refining how they reduce the impact of such frictions.  

Why care about tracking error?

What exactly is tracking error—and, ultimately, why should investors care about it?  

Let’s start with what tracking error is not. It’s not how much an ETF’s performance deviates from that of its benchmark index for a given period; that’s known as excess returns. It’s about how much those excess returns oscillate around the portfolio’s benchmark during that period.  

Tracking error is measured as the standard deviation of excess returns over time, and it’s an indicator of how consistently close or wide an index ETF’s performance is relative to its benchmark. While over the longer term absolute excess return is important, we find that many investors aren’t paying as close attention to the volatility of excess returns.  

But why should investors be paying attention to that volatility? The simple answer is that for investors using indexed products, any uncertainty around performance adds uncertainty costs. Depending on an investor’s investment horizon, this uncertainty cost can be even greater than the expense ratio or trading spread.  

A primary driver for investors buying an index ETF is to gain exposure to a specific slice of the market. When an ETF closely tracks its benchmark, and an investor who holds it sees that the performance they experience doesn’t deviate much from that of the benchmark, then that investor can feel confident that they’ve gained the exposure they sought.  

Investors using index ETFs need to have a high degree of confidence that they’ll get their desired market exposure. Any deviation from what the market is returning can add costs—which, again, is why minimizing tracking error is so important. If, as an investor, you allocate to an S&P 500 ETF, the choice for such exposure is generally driven by a capital market view. If a tracking error on a strategy is too wide, you could be correct on your capital market view—but your portfolio return won’t actually reflect what the market has done.  

Fixed income ETFs

Equity index fund managers seek to replicate their underlying index’s holdings. However, thanks to the negotiated nature of the fixed income market, it’s nearly impossible for a fixed income index fund manager to do the same.  

Instead, these managers must optimize their portfolios to match the index as best as they can, matching key characteristics of the index such as duration and yield to trace the index’s performance as closely as possible. Because of this, fixed income index ETFs are more vulnerable to tracking error than equity index ETFs are, and the error can be higher.

Given the distinct challenge of fixed income, conducting due diligence on fund sponsors is a crucial step toward ensuring that you are allocating to the product with the best chance of replicating benchmark returns.

We’ll look at some specific fixed income ETF case studies below. But first, a bit more background about tracking error to set the stage.

Tracking error in context

Low expense ratios are eye-catching, and can be an asset, but if a relatively inexpensive ETF also has significant tracking error, that advantage can be eroded.  

Time is also an important consideration when it comes to tracking error. In the short term, a high tracking error means higher uncertainty in performance, thus eroding the value of a tactical trade. In the long term, tracking error can be used to evaluate how consistently an index fund manager is meeting benchmark returns over time.

So, while a low expense ratio is important, a lower tracking error suggests a reduced likelihood of incurring costs from volatile performance, no matter your investment horizon.

Examining tracking error up close

With all of this in mind, we turn our attention to three index ETFs and some of their characteristics, including tracking error.  

We’ll look at three competing municipal bond ETFs, each of them with holdings across the broad municipal yield curve: Vanguard Tax-Exempt Bond ETF (VTEB), iShares National Muni Bond ETF (MUB), and Schwab Municipal Bond ETF (SCMB).

First, we compare VTEB, which launched on August 21, 2015, with MUB, which launched on September 7, 2007. We also compare VTEB with SCMB, which launched on October 12, 2022.  

The table shows a range of monthly excess returns and tracking error for these ETFs over time. The excess returns measure a straight arithmetic performance deviation over the given period. The tracking error—the more meaningful metric—shows the consistency of keeping the fund’s returns in line with its benchmark. In other words, a higher tracking error means a higher risk of being out of sync with the benchmark’s performance. (Full standardized performance data for these ETFs is located at the end of this article.)

Excess returns and tracking error for three competing ETFs 

Notes: VTEB seeks to track the S&P National AMT-Free Municipal Bond Index; MUB seeks to track the ICE AMT-Free US National Municipal Index; and SCMB seeks to track the ICE AMT-Free Core U.S. National Municipal Index. The three ETFs have similar investment objectives based on their prospectuses: VTEB seeks to track the performance of a benchmark index that measures the investment-grade segment of the U.S. municipal bond market; MUB seeks to track the investment results of an index composed of investment-grade U.S. municipal bonds; SCMB seeks to track as closely as possible, before fees and expenses, the total return of an index that measures the performance of the U.S. AMT-free municipal bond market. Index ETFs in the Muni National Intermediate Morningstar category—the category for each of the three ETFs shown—exclude strategic beta and sustainable-fund strategies.

Sources: Vanguard calculations, using data from Morningstar as of December 31, 2023 (excess returns range and tracking error); most recent prospectus for each ETF as of December 31, 2023 (expense ratio).

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.  

Note: There may be other material differences between products that must be considered prior to investing. 

The charts below show the oscillation of three ETFs’ excess returns over time—and also point to why tracking error is a more meaningful metric than excess returns.  

Monthly excess returns for three competing ETFS 

Past performance is not a guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.


Notes: Bars represent an ETF’s monthly excess returns; dotted lines represent the bounds of the largest excess returns recorded during the given period; shaded areas represent the range between those bounds. For VTEB and MUB, the period shown is December 31, 2018, through December 31, 2023. For SCMB, the period shown is November 30, 2022, through December 31, 2023. Excess returns for each ETF are measured against its primary prospectus benchmark. The three ETFs are similar in that they all span the municipal bond yield curve.

Sources: Vanguard calculations, based on data from Morningstar, Inc., as of December 31, 2023.

Each investor, of course, would have a unique entry and exit point along these timelines, and these specific points will help determine whether their investment underperforms or outperforms the relevant benchmark.  

Even so, VTEB’s returns are distributed more narrowly around those of the relevant benchmark. At the end of any given period, ETF returns clustering tightly around benchmark returns typically results in lower tracking error.  

In other words, greater volatility of excess returns translates into more uncertainty around excess returns. And—again—the tighter the tracking error, the more likely it is that you’ll avoid the cost of deviating from the market’s performance, and the easier it is to formulate thoughtful asset allocation.

SCMB only came to market in October 2022; its track record is relatively limited. Still, as these charts show, its excess returns range and its tracking error both exceed those of VTEB and MUB, thus potentially nullifying the benefit of a lower expense ratio.  

Vanguard’s value

In the end, when it comes to managing index funds—especially fixed income index funds—it’s crucial not to mistake “boring” for “easy.”  

Vanguard has spent decades perfecting indexing and controlling tracking error. Our size allows us to maintain a deep and experienced team of sector specialists, and we invest in the necessary technology to manage this level of complexity.  

Indexing is deep in our DNA, and as an investor-owned company in the asset management industry we’re constantly focused on maximizing investor outcomes and aren’t driven by a profit incentive.* Our approach to index optimization in fixed income might be the single biggest differentiator at Vanguard. Anchoring to important indexing factors—matching an index’s duration, emphasizing crucial exposure along the duration curve, and accurately calibrating exposure to different issuers and sectors—is all part of our seasoned approach to indexing.

This commitment to ensuring that investors keep as much of their return as possible through low expenses and low tracking error is part of what we call The Value of Ownership.

Standardized performance of VTEB, MUB, AND SCMB 

The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so investors’ shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit our website at vanguard.com/performance. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. There may be other material differences between products that must be considered prior to investing.

Sources: Returns are as per Morningstar, Inc., as of December 31, 2023; expense ratios are as per the most recent prospectus for each ETF as of December 31, 2023.


Legal notices

For more information about Vanguard funds, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.  

All investing is subject to risk, including the possible loss of the money you invest.  

Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.  

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

* Vanguard is owned by its funds, which are owned by Vanguard’s fund shareholder clients.  

Founded in 1975, Vanguard is one of the world's most respected investment management companies. The firm offers investments; advice and retirement services; and insights to individuals, institutions, and financial professionals. Based in Malvern, Pennsylvania, Vanguard has offices worldwide and manages more than $8 trillion* on behalf of more than 50 million clients*. Vanguard operates under a unique, investor-owned** structure and adheres to a simple purpose: To take a stand for all investors, to treat them fairly, and to give them the best chance for investment success.