As the ETF world has continued to grow over the past few years, funds have stretched beyond the typical benchmarks such as the S&P 500 or the DJIA and into more exotic or extensive indexes. While this has been welcomed news for investors seeking further diversification, there has also been a downside to this expansion as well. These more unique benchmarks are much harder targets for ETF issuers to hit, and as a result tracking error for ETFs has surged higher in recent years–hitting 0.84% in 2009. However, recent data suggests that ETF issuers are increasing their accuracy and are becoming better at matching their benchmark’s returns. According to a report from Morgan Stanley Smith Barney, tracking error declined significantly in 2010 for all U.S.-listed ETFs, down to just 0.57%. Meanwhile, in the international fund segment, where it can be more difficult to match benchmarks thanks to timezone differences and illiquid markets, ETFs missed their marks by an average of 1.1%–down from 1.94% in the previous year [see Myths About ETF Liquidity].
Some amount of tracking error is inevitable in most ETFs, especially those that seek to replicate benchmarks consisting of thousands of securities in which buying every component is not only difficult but is in many cases, downright impossible. Take for example the Barclays Capital U.S. Aggregate Bond Index, the benchmark that underlies the iShares Barclays Aggregate Bond Fund (AGG). The popular bond fund holds over 700 different securities, a robust number of bonds, but the overall index has more than 8,000 in total–meaning that AGG has less than one-tenth of the total number of securities in its underlying index. While most of these 7,000+ securities that are not included in AGG are very small, a solid collective performance by this group can produce tracking error that the ETF simply cannot account for in any realistic way.
Still, some ETFs managed to miss their benchmarks by rather large margins, including 11 funds that missed by more than 300 basis points. The worst case of this was the SPDR S&P Emerging Europe ETF (GUR) which trailed its benchmark, the S&P European Emerging BMI Capped Index by 590 basis points on the year. This gap could be due to the fund’s focus on illiquid markets in eastern Europe such as Hungary and the Czech Republic [see Who Else Wants A Real Eastern Europe ETF?]. With low trading volumes and volatile returns in much of the region, it should come as no surprise to many investors that GUR was the worst performer in 2010 in terms of tracking error (if its any consolation, the fund has gained almost 20% in the past year).
How To Avoid
While all ETFs will miss their benchmarks by at least a very small amount, ETNs on the other hand represent an option to avoid tracking error. Exchange-traded notes function as unsubordinated debt securities that are sold by an issuer. In these notes, investors are promised to be paid a return equal to the underlying benchmark [see more on the Basics Of ETN Investing].
However, investors should note that ETNs don’t actually hold the securities in question and that if the issuer goes belly-up it could be difficult for investors to recoup all of their money–something that ETF investors never have to worry about. So there is a trade off and investors must weigh the credit risk of an ETN with its ability to eliminate tracking error in order to determine which security is best for their portfolio [see ETN Investing Facts And Fallacies].
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Disclosure: No positions at time of writing, photo is courtesy of Christian Gidlof.