Why You Shouldn't Pick an ETF on Expense Ratio Alone -- Tracking Error and the Discrepancy Rate Decide Your Real Cost

Low expense ratio, worse returns -- how does that happen?

Tracking error -- how far behind the index the fund falls

Tracking error is the gap between the return of the underlying index an ETF is supposed to follow and the return the ETF actually delivers. Even an ETF with a 0.05% expense ratio can post worse-than-index returns because of trade timing, when dividends get reinvested, or how quickly the fund reflects changes to the index's constituent stocks. Conversely, an ETF charging 0.15% but managed more precisely, with smaller tracking error, can end up outperforming the cheaper-looking option over the long run. In short, the expense ratio is only part of the cost -- it doesn't tell you the whole performance story.

The discrepancy rate -- a separate loss that only hits when you trade

The discrepancy rate is the gap between an ETF's net asset value (NAV, what the fund's holdings are actually worth) and the price it trades at on the market. If tracking error is a management problem, the discrepancy rate is a trading problem. ETFs with thin trading volume, or ones holding overseas assets that are hard to price in real time, tend to see wider discrepancy rates. Buy at a moment when the price sits above NAV (a positive discrepancy) and you've effectively paid more than the fund's holdings are worth -- starting out already behind by that gap. Sell when the price sits below NAV (a negative discrepancy) and you're getting less than fair value on the way out.

Why you need to look at all three numbers together

Put simply, expense ratio, tracking error, and the discrepancy rate are costs that show up at different stages. The expense ratio is a fixed cost quietly deducted from NAV a little at a time, every day you hold the fund. Tracking error is a performance measure of how precisely the manager replicated the index. The discrepancy rate is a price distortion that only exists at the exact moment you buy or sell. If you picked the cheapest-looking product by expense ratio alone and the real return still falls short of what you expected, suspect either a large tracking error or that you traded while the discrepancy rate had widened.

Where to check these numbers

All three figures are disclosed on each asset manager's product page or through the Korea Exchange's ETF information portal. The expense ratio is stated as an annual percentage in the prospectus and simplified prospectus. Tracking error is published and regularly updated by the manager, typically shown on a trailing 1-year and 3-year basis. The discrepancy rate changes in real time, so you have to compare the live NAV (or iNAV, the real-time estimated net asset value) against the current price on the order book at the moment you trade. Discrepancy rates can spike briefly right after the market opens or just before it closes, when trading is heaviest -- trading during calmer mid-session hours is one common way to limit losses from a widened discrepancy rate.

How to choose when several similar ETFs exist

If multiple asset managers offer ETFs tracking the same index, ① compare expense ratios first, ② then check which candidate has kept its trailing 1-year tracking error small and stable, and ③ finally look at whether typical trading volume (value traded) is high enough that the discrepancy rate doesn't widen much. An ETF with very thin trading volume can lose -- or lose even more -- of its expense-ratio advantage to discrepancy-rate losses at the moment you actually buy or sell. ETFs tracking overseas indices also tend to see wider discrepancy rates because domestic and overseas market hours don't overlap, which is worth factoring in too. By the same logic, bond ETFs layer face-rate and market-rate mechanics on top of all this, so they give you one more thing to compare than equity ETFs do.

Dividend and distribution reinvestment style matters too

Tracking error is also affected by whether dividends (distributions) get reinvested the same way the index assumes. Distributing ETFs pay distributions out to investors in cash, while accumulating (or "total return") ETFs reinvest distributions to track the index's total-return methodology more closely. Two ETFs tracking the identical index can still diverge in long-run cumulative returns if they differ on this point, so it's worth checking whether "total return" or "TR" appears in the product name. If you're parking a lump sum for a short period, it may make more sense to compare a term deposit's early-withdrawal interest structure before reaching for an ETF at all, and if you're saving long-term, it's also worth weighing the expected return against a government-matched product like the Youth Leap Account.

Checklist

① Among ETFs tracking the same index, compare the expense ratio first. ② Prioritize the candidate with the smallest, most stable trailing 1-year tracking error. ③ Check typical trading volume (value traded) to see whether the discrepancy rate tends to stay narrow. ④ Trade during calmer mid-session hours, comparing NAV (or iNAV) against the current price before you do. ⑤ Check whether the fund is distributing or accumulating (TR) based on your holding goal.