Why are there several ETFs on the same index?
Major stock indexes are often tracked by an ETF from almost every fund company, so three or four products can follow the same index. Their names and holdings look nearly identical, yet after one, five, or ten years their returns differ. Most of the difference comes from costs and how each fund is run.
This guide explains what an index and an ETF each are, how an ETF tracks its index, and what investors actually pay, using a hypothetical product comparison. It also lists what to check in a prospectus.
What an index and an ETF do
A stock index summarizes the prices of stocks selected by a set of rules into a single number. The index itself cannot be bought; it is just a calculation. An ETF buys actual shares to produce returns close to the index and lets investors trade that basket on an exchange like a stock.
The SEC's investor bulletin on mutual funds and ETFs explains that index funds seek to achieve approximately the same return as a particular index, by buying all the securities in the index or a representative sample. So the first step in choosing an ETF is knowing which index it follows and what that index's rules are.
Tracking methods and costs
Holding every stock in the index at its index weight is full replication. For indexes with many constituents or hard-to-trade stocks, some funds use sampling, holding a representative subset designed to behave similarly. Sampling can cut costs but may widen the gap from the index.
Investors pay more than the expense ratio. Trading costs inside the fund, the lag between receiving dividends and reinvesting them, and the bid-ask spread paid when buying or selling the ETF all reduce returns.
A hypothetical comparison
The table compares three hypothetical ETFs tracking the same index.
| Item | ETF A | ETF B | ETF C |
|---|---|---|---|
| Tracking method | Full replication | Full replication | Sampling |
| Expense ratio | 0.03% | 0.15% | 0.50% |
| Tracking difference, last year | -0.05% | -0.20% | -0.70% |
| Average bid-ask spread | 0.01% | 0.05% | 0.30% |
| Fund assets | $5 billion | $800 million | $30 million |
Following the same index, ETF C trailed it by 0.7% in a year and charged an extra 0.3% spread on each trade. Over ten years, the gap becomes large.
Watching tracking difference
Tracking difference is the gap between the ETF's return and the index's return over a period. Most funds trail by about their expense ratio, but trading costs and operational efficiency can make the gap wider, while income from lending securities can make it narrower. A low fee paired with a wide tracking difference suggests something in how the fund is run.
Tracking error measures how much that gap varies. Small, stable tracking difference indicates a fund that follows its index faithfully. Both figures are usually available on the provider's website or in shareholder reports.
Checking the holdings
Even a broad equity ETF can be dominated by a few stocks depending on the index rules. In market-cap-weighted indexes, the top handful of companies often make up 30% to 40% of the total, so diversification can be narrower than it appears.
If the index uses other rules, such as equal weighting, dividends, or a theme, its methodology and risks need separate attention, as the SEC's bulletin on smart beta funds explains. A product with "index" in its name is not necessarily the same kind of investment as a broad market-cap index fund.
Reading the prospectus
ETF prospectuses and shareholder reports are available on EDGAR and providers' websites. A practical order:
- Identify the index, its construction rules, and its rebalancing schedule.
- Check whether the fund uses full replication, sampling, or derivatives.
- Compare the expense ratio with one-year and three-year tracking difference and tracking error.
- Look at average trading volume and bid-ask spread to estimate the cost of trading.
- Review the weight of the top ten holdings and sector weights to see how diversified the fund really is.
Limits of ETF comparisons
Past tracking difference may not continue, and small ETFs can be closed. When a fund closes, holders receive the value at the time, but they have effectively been forced to sell at a moment they did not choose.
The products compared above are hypothetical. When choosing a real ETF, use the latest prospectus and provider disclosures with their dates, and compare index rules and total cost rather than names.