An index is an imaginary portfolio of underlying securities representing a particular market with particular attributes and/or a theme. Most ETFs track a particular index in which the fund tries to replicate the index holdings of securities and follows closely the movement of the index. This style of investment is generally known to be a passive style of investment[?]. The illustration below summarises the creation of an ETF with a basket of securities and how it relates to a selected benchmark index.
An ETF does not try to beat the benchmark index but rather mimics its movement. The difference between the ETF’s net asset value (NAV) and the value of the index is called tracking error. The lower the tracking error is the better the fund in tracking the index.