How can an ETF beat the index it tracks?

Two ways, both mundane. Securities lending: the fund lends its holdings and returns most of the fee income to investors. And withholding tax: index providers usually assume the maximum rate on dividends, while an Irish-domiciled fund pays 15% on US dividends under the treaty. Recovering that gap can exceed the ongoing charge.

Should I choose a fund on tracking difference instead of TER?

It is the better measure of what the fund cost, so prefer it where it is available — but it is backward-looking and noisy over short periods. Use it to sanity-check the headline charge rather than to split hairs between two funds a basis point apart.

Tracking difference vs TER: what an ETF really costs

The ongoing charge is an input, not an outcome. What you actually lost to the fund is the gap between the index return and the fund's return — the tracking difference — and it is routinely different from the charge, sometimes in your favour.

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How it works

Two things move the fund away from its headline charge in opposite directions. Securities lending income is returned to the fund and offsets costs. Withholding tax on dividends works the other way, except where an Irish domicile recovers more than the index assumes — which is why some Irish funds tracking US indices show a negative tracking difference and genuinely beat their benchmark after fees.

What it assumes

Tracking difference is measured over a past period and varies year to year: a single figure is a summary, not a constant. It also depends on which index variant the comparison uses — net, gross or total return — and those differ by exactly the withholding-tax treatment at issue here.

Common questions

How can an ETF beat the index it tracks?: Two ways, both mundane. Securities lending: the fund lends its holdings and returns most of the fee income to investors. And withholding tax: index providers usually assume the maximum rate on dividends, while an Irish-domiciled fund pays 15% on US dividends under the treaty. Recovering that gap can exceed the ongoing charge.
Should I choose a fund on tracking difference instead of TER?: It is the better measure of what the fund cost, so prefer it where it is available — but it is backward-looking and noisy over short periods. Use it to sanity-check the headline charge rather than to split hairs between two funds a basis point apart.

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