Understanding tracking error is key to savvy ETF investing

EXCHANGE-TRADED products may have only just entered the mainstream and been accepted by the European investment community, but some market commentators are already questioning whether the end is nigh for these funds.

This was indeed the question posed by financial blogger Felix Salmon, citing news reports of a recent piece of research from Morgan Stanley which showed that the average US ETF underperformed its benchmark by 125 basis points in 2009, compared to 52 basis points in 2008.

On the face of it, an increase in the tracking error is not a good sign for investment products such as exchange-traded funds (ETFs). The whole point of ETFs is that they track the underlying index as closely as possible. A large tracking error hurts investors because the performance of the fund is no longer predictable.

Although the report only looked at US funds, should European investors also be worried about the performance of their ETFs? Thankfully, it appears that the causes of the wider tracking error in the American funds were specific to the US market and are unlikely to pose a problem this side of the Atlantic. When US exchange-traded funds are created, the issuer is required to hold a portfolio reflective of the constituent stocks in the benchmark index rather than hold it in cash.

During the financial crisis, nervous investors preferred to use American Depository Receipts (ADRs) to invest overseas rather than buying international shares. ADRs are written by investment banks, and give you the economic return of an international equity, but keep the money in the US and in dollars.

If issuers are accepting ADRs for the creation and redemption of ETFs, as US issuers were, then you will get tracking error from the currency effect and the inefficiencies inherent in ADRs. In contrast, the construction of physically backed European ETFs is cash-based and consequently would not suffer from this.

However, while European ETFs’ design means they are less prone to a large tracking error, retail investors should still be aware of why such errors occur and how to select ETFs wisely to ensure that they get the best performance possible.

Most of the time the tracking error of a fund is miniscule – perhaps only a few tenths of a percentage point – but sometimes, as we saw in the US in 2009, a number of factors can all occur together to widen the gap between the index’s performance and that of the ETF which tracks it.

The main reason for the disparity between the performance of the underlying index and the ETF is cost. Even if the ETF tracks the index perfectly, it will always underperform the benchmark by the amount of the fees that are deducted from the fund’s returns. Lower expense ratios are normally passed on to the investor through higher returns, so it is worth shopping around to find the ETF that gives you the best performance as well as the investment that you want.

Providers charge fees, known as the total expense ratio, to cover management and operational costs. And in the case of synthetically-created exchange traded commodities there might also be an index replication fee to cover the cost of creating a structure and collateralising the instrument. When it comes to commodities, it is often inappropriate to compare the return of the ETF and the actual commodity – you would have to incorporate costs – such as for storage – that would affect the physical commodity into your comparison.

For example, physically backed ETFs are more susceptible to a larger tracking error than swap-backed funds, which invest in a swap offered by banks to provide index exposure. These synthetically-created ETFs are less prone to tracking errors, especially when the underlying index is liquid. Indeed, the returns are often the same as the underlying index.

While it might seem obvious to choose the ETF with the lowest fees, there are other factors that investors need to worry about, says Deutsche Bank ETF strategist Christos Costandinides. When selecting which ETF to invest in, he says that you should be concerned about how the fund’s returns are created and if there are any practical difficulties involved in the replication.

Managers of physically-backed ETFs – usually equity or fixed income funds – try to generate additional returns for investors by lending out the securities they hold for the ETF and charging interest on them. This sounds like an ideal way to offset the cost of the fund, but Costandinides points out that while managers routinely lend out securities to reduce the tracking errors that comes from management fees, the income doesn’t entirely flow back to the investor – about 50 per cent is usually returned, but the other half is split between the fund manager and the custodian of the securities that manages the lending. Costandinides adds that if a large amount of the ETF holdings are being lent out at any one time and there is suddenly a wave of redemptions, this can cause difficulties for the ETF and add to its tracking error.

The most important thing is to understand what you are buying. Check whether you will be charged maximum creation or dissolution fees – these can be substantial and are often buried in the fund’s prospectus. When it comes to ETFs and tracking error, investors should take the time to understand what they are buying, how it operates and what the fees are. Sometimes, it is worth paying slightly more for a less complex fund. For example, Invesco Perpetual’s head of listed sales Tim Mitchell says that while physically backed ETFs might be more prone to tracking error, they are less complex than swap-backed ETFs and this can appeal to investors.