ETF Tracking Error: What It Is and How It Happens
December 09, 2009 at 1:00 pm by Tom Lydon
Exchange traded funds (ETFs) are useful tools in the investment world, but they are not without flaws. One such flaw many an investor may have heard about is tracking errors in ETFs.
All ETFs tend to have some tracking errors, and tracking errors can be either positive or negative, according to NobleTrading. The tracking errors are seen as a standard deviation from an ETF’s benchmark. (Reasons ETF tracking errors occur).
ETFs that seek to reflect broad indexes usually have lower tracking errors when compared to those reflecting certain sectors, indexes or foreign markets. Investors should note that ETF tracking errors are interpreted against its returns.
Let’s take a look at some of Noble Trading’s reasons ETF tracking errors:
Expense ratios. Specialty ETFs come with an active management ETF portfolio. The active management includes costs that result in tracking errors.
Portfolio optimization. At times, ETFs use samples since it is not possible to buy all stocks or securities of an index, which can give rise to tracking errors.
Lending fees. The total ETF return can be distorted by lending fees collected for hedge funds from short-selling.
Diversification constraints. Sector-specific ETFs may find it hard to perfectly mirror a sector because some companies make up a huge chunk of a sector, and ETFs aren’t allowed to invest more than a set percentage of assets in a single stock.
Cash holdings. Some ETFs require cash holdings to buy/sell securities.
Contango and backwardation. These two phenomena are associated with commodity ETFs, which may have roll futures that result in high tracking errors. (The four types of commodity ETFs).
Capital gains distributions and hedging risks. Both of these investment features could result in errors, as well.
Showing posts with label ETF Tracking Errors. Show all posts
Showing posts with label ETF Tracking Errors. Show all posts
Tuesday, February 23, 2010
What's Behind the Jump in ETF Tracking Errors?
Last year may have been a breakout year for exchange traded funds, but some ETFs did not perform as well as they should have, as the disparity between ETFs and the benchmarks they try to reflect widened in some cases.
According to a study conducted by Morgan Stanley, ETFs veered away from their benchmarks by an average of 1.25% in 2009, a gap more than twice as much as the 0.52% average for 2008, reports Ian Salisbury for The Wall Street Journal. [Causes of Tracking Error in ETFs.]
Everyone focuses on the benefits of ETFs – transparency, low fees, intraday liquidity and so on – but if they fall short of their indexes, they lose their advantage over active mutual funds and ETFs that do track their benchmarks. As ETFs grow, it’s important that they perform as closely as possible to their benchmarks.
The tracking error is seen as a result of the recent proliferation of ETFs that target niche investments or areas where trading is less liquid. 54 ETFs had tracking errors of more than 3% and some even had more than 10% last year. For instance, the iShares MSCI Emerging Markets Index (EEM) gained 71.8% in 2009 while the benchmark returned 78.5%.
Large tracking errors make fund values unpredictable at any given time. Still, funds that that underperform one year may outperform in the next – tracking error may occur in both the negative and positive direction. iShares portfolio manager Dina Ting says that, “over the long-term, we’ve delivered on our objectives.”
ETF tracking error may also be a result of the makeup of a portfolio. Some ETFs include every stock or bond from a target index, but many bond ETFs hold a representative sample, which makes them more vulnerable to tracking errors. Other reasons tracking errors might occur is because of limits to a specific stock weighting within an ETF or the existence of hard-to-trade securities. [Tracking Error: What It Is and How It Happens.]
According to a study conducted by Morgan Stanley, ETFs veered away from their benchmarks by an average of 1.25% in 2009, a gap more than twice as much as the 0.52% average for 2008, reports Ian Salisbury for The Wall Street Journal. [Causes of Tracking Error in ETFs.]
Everyone focuses on the benefits of ETFs – transparency, low fees, intraday liquidity and so on – but if they fall short of their indexes, they lose their advantage over active mutual funds and ETFs that do track their benchmarks. As ETFs grow, it’s important that they perform as closely as possible to their benchmarks.
The tracking error is seen as a result of the recent proliferation of ETFs that target niche investments or areas where trading is less liquid. 54 ETFs had tracking errors of more than 3% and some even had more than 10% last year. For instance, the iShares MSCI Emerging Markets Index (EEM) gained 71.8% in 2009 while the benchmark returned 78.5%.
Large tracking errors make fund values unpredictable at any given time. Still, funds that that underperform one year may outperform in the next – tracking error may occur in both the negative and positive direction. iShares portfolio manager Dina Ting says that, “over the long-term, we’ve delivered on our objectives.”
ETF tracking error may also be a result of the makeup of a portfolio. Some ETFs include every stock or bond from a target index, but many bond ETFs hold a representative sample, which makes them more vulnerable to tracking errors. Other reasons tracking errors might occur is because of limits to a specific stock weighting within an ETF or the existence of hard-to-trade securities. [Tracking Error: What It Is and How It Happens.]
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