Why Do Thinly Traded Index Constituents Increase Tracking Error?
An index can include a security that trades only a handful of times a day, priced at whatever the last trade happened to be. A fund trying to hold that same security in the right proportion faces a much harder task than the index’s tidy math would suggest.
The short answer
An index calculates its value using the latest available price for each constituent, regardless of how easy that security actually is to buy or sell. A fund tracking the index, however, has to execute real trades, and thinly traded securities often have wide gaps between buying and selling prices along with limited volume available at any given moment. That combination makes it harder for the fund to transact at a price close to the one the index effectively assumed, which shows up as added tracking error, particularly around the dates when the fund needs to adjust its holdings.
What “thinly traded” actually means
A security is thinly traded when relatively few shares change hands on a typical day, whether because the underlying company is small, the market it trades in is less developed, or investor interest in that particular security is simply limited. This is common in indexes weighted toward smaller companies or newer markets, where market capitalization can vary enormously across constituents and the smallest names may see very little daily activity compared to the index’s largest holdings.
Wider spreads, smaller order sizes
Illiquid securities tend to have a wider bid-ask spread than heavily traded ones, meaning the price a fund pays to buy and the price it receives to sell are further apart. A fund also often can’t place a large order without moving the price against itself, since there simply isn’t enough volume at the current price to absorb a sizable trade. Both effects push the fund’s actual execution price away from the reference price the index used, and that gap becomes part of the fund’s tracking error.
Why this matters more at reconstitution time
The problem is usually mildest on an ordinary trading day and most pronounced when the fund needs to rebalance to match an index change, because that’s when the fund is forced to trade in a specific security on a specific date rather than choosing its own timing. A fund with more flexibility about when to trade a thinly traded name can sometimes work an order patiently to get a better average price; a fund tied to a reconstitution deadline has much less room to be patient.
Emerging and small-cap indexes face this most
Indexes covering emerging markets or small companies tend to include a higher proportion of thinly traded constituents than indexes built from the largest, most established companies, simply because trading volume tends to track company size and market development. Funds tracking these indexes often show somewhat higher tracking error on average than funds tracking large, liquid benchmarks, not necessarily because they’re managed less carefully, but because the underlying securities are inherently harder to trade cleanly.
What to weigh
Some funds address this by using sampling or optimization techniques that reduce exposure to the very smallest, least liquid names, trading a small amount of precision for meaningfully lower trading costs. For an investor comparing funds that track similar but not identical indexes, it’s worth recognizing that a somewhat higher tracking error in a small-cap or emerging-market fund isn’t automatically a sign of poor management — it may simply reflect the reality of trading in less liquid markets.