Understanding Index ETF Performance

Index ETFs make it easy to get diversified market exposure — and for many investors, they’re the go-to alternative to picking individual stocks. But here’s the surprise: even ETFs that focus on the same region or sector can deliver noticeably different returns. The reason? It comes down to index construction and tracking. Let’s take a closer look.

There are two main reasons. 

1. The index your ETF tracks matters. Not all indexes are the same due to how they’re constructed. Even within a single market — say, Canadian stocks — different indexes may include different companies, use different weighting schemes and follow different rebalancing schedules.
2. ETFs don’t always track their index perfectly. Tracking difference and tracking error — two related but distinct concepts — can both affect ETF performance. Let’s take a closer look at how indexes are built, how ETFs try to mirror them and how understanding these mechanics can lead to smarter investing decisions.

Different indexes can have very different compositions, even when they represent the same geographic region or industry group. An index isn’t just a list of companies. It’s built using a set of rules — its methodology — that determines: 

• Which securities are included
• How they’re weighted
• How often the index is rebalanced 

These rules shape the index’s composition and, in turn, its performance, sector exposure for broad indexes, and risk profile. ETFs that track that index will reflect these same characteristics.

• Tracking difference is the actual return gap between an ETF and its benchmark over a given period — often driven by fees, trading costs, and how the ETF handles dividends. Larger ETF providers may be able to offer lower fees due to economies of scale, which can help reduce tracking difference. Check the fund description for information.
• Tracking error measures the volatility of that difference — how consistently the ETF follows the index over time.

For broad, liquid indexes like the S&P 500 or TSX 60, both tracking difference and tracking error are usually small — these indexes are relatively easy to replicate.

That said, all index ETFs face some potential frictions, including:

• Timing mismatches between ETF trades and index changes
• Cash drag from uninvested dividends or new fund inflows

For ETFs that track overseas markets, smaller companies, or specialized sectors, additional challenges may apply:

• Currency differences between investor flows and the fund’s holdings
• Illiquidity of certain securities
• Differences in trading hours between the fund manager and the markets where the index constituents trade

Even if two ETFs follow the same index, performance can diverge slightly depending on how efficiently each one handles these complexities.

Index investing is often described as “passive” — but choosing the right index and the right ETF to track it requires active thinking. 

Behind every index is a set of rules that determines what you’re really investing in. To make informed decisions:

• Understand the index’s construction, sector exposure, and rebalancing schedule
• Evaluate both tracking difference and tracking error when comparing ETFs — especially in international or niche markets

What looks like a small difference in index construction or fund execution can lead to surprisingly different returns.

When two index ETFs seem similar on the surface but behave differently, a closer look under the hood — at both the index and the ETF’s tracking — often reveals why.