Set out where ETF tracking error comes from

Tracking difference is the gap between an ETF's return and its index return over a period; tracking error is the variability of that gap, usually the standard deviation of periodic return differences. Sources include fund expenses, which make returns lag the index, and representative sampling instead of full replication. Transaction costs when the index changes and cash drag from dividends awaiting reinvestment widen the gap, while securities lending income, which can offset costs, narrows it. Regulatory diversification limits and, for international funds, differences in valuation timing and fair-value pricing complete the list. Futures-based funds also track imperfectly because of roll costs. A fund can show a steady shortfall with low tracking error. The trap is confusing the two: a constant fee drag produces tracking difference but almost no tracking error.