It’s hardly uncommon for those buying a new laptop or flat screen television to spend hours researching the features and comparative advantages each model offers, yet far too often investors fail to apply the same effort when buying exchange traded funds (ETFs).
Beyond the obvious parameters like annual cost, recent performance or risk profile, few investors spend the time to check over important features such as what index the fund is intended to track, and how well it has succeeded in tracking that index over time.
Most ETFs are managed to track an index instead of employing a professional manager, and inevitably there is a lag between the performance of the index and the fund’s net asset value.
Part of this has to do with the fact that all ETFs charge investors an annual fee to recoup the costs of running the fund, something that is not reflected in the performance of the index.
Yet there is still a degree of divergence even after the effect of expenses is discounted known as “tracking error,” and it can vary significantly from fund to fund.
It would be nice to think that as the ETF industry matures and the remaining bugs get worked out of the system, tracking error would shrink into insignificance, but unfortunately that is not the case.
The problem got worse in 2008 and again in 2009, according to a study published this summer by a group of ETF analysts at Morgan Stanley, which found that tracking error across all US-listed ETFs averaged 125 basis points in 2009, compared with about 50 basis points in 2008.
Even worse, the study “found a broader range and magnitude of tracking error in 2009 than 2008,” with 37.5% of ETFs suffering from tracking error larger than 100 basis points compared with just 13.5% in 2008.
At the same time, the number of ETFs reporting tracking error of less than 25 basis points declined from 44.6% to 22%.
Sources of the Problem
Beyond the obvious effect of fees and expenses, there are several ways that tracking error can creep into an ETF, and it is important to understand what they are when evaluating ETFs.
Some ETFs use a methodology of full replication, in which all the index constituents are owned in their proper proportion.
But full replication would be too costly for other indexes, and managers opt instead to use representative sampling to achieve a similar result. While this usually works pretty well, it can lead to a divergence if the performance of index members that were left out varies from the others.
Most of the tracking error stemmed from the effects of sampling, the study said; full replication ETFs “were still able to track their underlying indices quite closely.”
Index members also change, and it is not always possible for the portfolio to match each change simultaneously.
Furthermore, there are some ETFs that track indices whose weightings conflict with the portfolio diversity requirements mandated by the Securities and Exchange Commission. (The SEC prohibits funds from owning portfolios in which one issuer accounts for more than 25% of total assets, or in which the sum of issuers with portfolio weights of more than 5% exceeds 50% of the fund’s assets.)
For equity funds, how the fund handles dividends can be lead to tracking error, as well.
As a group, international and global ETFs tend to have the largest tracking errors, the study said, because the underlying markets are more difficult to access, which encourages portfolio managers to use representative sampling rather than full replication.
Emerging market ETFs were a particular problem, accounting for seven of the nine international ETFs with the largest tracking error and trailing their target index by an average of 836 basis points.
The PowerShares FTSE RAFE Emerging Markets ETF (PXH), the PowerShares DWA Emerging markets Technical Leaders Portfolio (PIE), the SPDR S&P Emerging Europe ETF (GUR) all missed their target index performance by more than 900 basis points.
Fixed-income ETFs also had difficulty tracking their target indices, due mostly to the illiquidity of the underlying index components.
The SPDR Barclays Capital High Yield Bond ETF (JNK), and the PowerShares High Yield Corporate Bond Portfolio (PHB), had the third and fourth largest tracking error of US-listed ETFs, at 1299 and 1099 basis points respectively.
The ETF with the largest tracking error in 2009, according to the study, was the Vanguard Telecom Services ETF (VOX), which was unable to replicate its target index, the MSCI US Investable Market Telecommunication Services Index, due to SEC diversification rules.
The fund missed its index by 1709 basis points in 2009, the study said, mostly due to the fact that it was unable to put 49.2% of its assets in AT&T, or 28% in Verizon, as the index calls for.
Luckily for investors, it outperformed the index instead of trailing it, but Vanguard still decided to change the tracking index to the MSCI US Investable Market Telecommunication Services 25/50 Index in February, 2010. MSCI created the “25/50” line of indices to address the diversity requirements specifically.
At a minimum, it is important to know whether an ETF is managed using representative sampling, and if so, how many holdings it has compared to its target index.
International ETFs and fixed income ETFs that target less liquid markets like high yield bonds should receive extra scrutiny.
Better still is to research the tracking error of a fund, and learn what has caused the error. And for those who can’t tolerate tracking error at all, there are — of course — exchange traded notes (ETNs) – which don’t own the underlying asset at all and are simply obligations of the issuer.
In essence, ETN investors drop the risk of tracking error in exchange for assuming the credit risk of the ETN issuer.