when there are thinly traded stocks in the benchmark index the etf provider can t buy them without pushing their prices up substantially so it uses a sample containing the more liquid stocks to proxy the index this is called portfolio optimization 
etfs are registered with regulators as mutual funds and need to abide by the applicable regulations of note are two diversification requirements 75 of its assets must be invested in cash government securities and securities of other investment companies and no more than 5 of the total assets can be invested in any one security 1 this can create problems for etfs tracking the performance of a sector where there are a lot of dominant companies indexes don t have cash holdings but etfs do cash can accumulate at intervals due to dividend payments overnight balances and trading activity the lag between receiving and reinvesting the cash can lead to a decline in performance known as drag dividend funds with high payout yields are most susceptible etfs track indexes and when the indexes are updated the etfs have to follow suit updating the etf portfolio incurs transaction costs and it may not always be possible to do it the same way as the index for example a stock added to the etf may be at a different price than what the index maker selected etfs are more tax efficient than mutual funds but have nevertheless been known to distribute capital gains that are taxable in the hands of unitholders although it may not be immediately apparent these distributions create a different performance than the index on an after tax basis indexes with a high level of turnover in companies e g mergers acquisitions and spin offs are one source of capital gains distributions the higher the turnover rate the higher the likelihood the etf will be compelled to sell securities at a profit some etf companies may offset tracking errors through security lending which is the practice of lending out holdings in the etf portfolio to hedge funds for short selling the lending fees collected from this practice can be used to lower tracking error if so desired international etfs with currency hedging may not follow a benchmark index due to the costs of currency hedging which are not always embodied in the mer factors affecting hedging costs include market volatility and interest rate differentials which impact the pricing and performance of forward contracts commodity etfs in many cases track the price of a commodity through the futures markets buying the contract closest to expiry as the weeks pass and the contract nears expiration the etf provider will sell it to avoid taking delivery and buy the next month s contract this operation known as the roll is repeated every month if contracts further from expiration have higher prices contango the roll into the next month will be at a higher price which incurs a loss thus even if the spot price of the commodity stays the same or rises slightly the etf could still show a decline vice versa if futures further away from expiration have lower prices backwardation the etf will have an upward bias leveraged and inverse etfs use swaps forwards and futures to replicate on a daily basis two or three times the direct or inverse return of a benchmark index this requires rebalancing the basket of derivatives daily to ensure they deliver the specified multiple of the index s change each day example of a tracking errorfor example assume that there is a large cap mutual fund benchmarked to the s p 500 index next assume that the mutual fund and the index realized the following returns over a given five year period given this data the series of differences is then 11 12 3 5 12 13 14 9 and 8 7 these differences equal 1 2 1 5 and 1 the standard deviation of this series of differences the tracking error is 2 50 