If you invest in exchange-traded funds (ETFs), you may have noticed they don't perform exactly like the indexes they are supposed to track. Costs and practical constraints get in the way and create what is known as tracking errors.
Aside from the commissions to buy and sell, many people equate the cost of an ETF to its management expense ratio (MER). But tracking errors, which includes the MER and other factors, may provide a more accurate picture.
A study by investment dealer Morgan Stanley found that the average tracking error for all U.S.-listed ETFs was 0.52 per cent in 2008. Some ETFs had higher errors than others. For example, the Vanguard Telecom Services fund VOX-N returned 2.2 percentage points less than its benchmark index.
No studies appear to have been done to examine Canadian funds. But some Canadian ETF providers publish estimates. Annualized tracking errors for Barclay Canada's iShares family range from 0.18 per cent for the iShares CDN Large Cap 60 Index Fund XIU-T to 1.06 per cent for the iShares CDN S&P 500 Currency-Hedged Index Fund XSP-T .
Let's take a look at five kinds of tracking errors.
1. Premiums/discounts to net asset value may occur when investors bid the market price of an ETF above or below the net asset value (NAV) of its portfolio of securities. This kind of tracking error is usually negligible because ETFs have an arbitraging mechanism for eliminating such discrepancies.
How does it work? When a discount exists, the ETF's agent has an incentive to buy ETF units and redeem them for stocks in the ETF basket. The buying bids the ETF's price up until the discount is gone. When a premium exists, the agent is motivated to transfer stocks into the ETF portfolio and create new units that can be sold on the market. This lowers the price until the premium is gone.
But this mechanism occasionally breaks down. For example, the United States Natural Gas ETF UNG-N was trading at a premium of nearly two per cent on July 10 because the creation of new units had to be suspended until regulatory approval was obtained.
Premiums and discounts as high as 5 per cent have arisen for thinly traded ETFs when stock markets open for daily trading on volatile days. That's because the ETF's agent may have difficulty gauging the prices of underlying securities in the first 10 to 20 minutes after the opening bell. End-of-day trading may present challenges, too.
2. Differences in NAV from the index may occur when the net value of the ETF's portfolio deviates from the index. The most obvious reason for this is the MER charged by the fund.
Another reason is “portfolio optimization.” When there are illiquid stocks in the index basket, the ETF provider can't buy them without pushing their prices up, so it uses a sample containing the more liquid stocks to represent the index.
Yet another reason: securities in the index basket sometimes have to be replaced when they no longer meet the criteria for inclusion. The ETF provider needs to follow suit and update its portfolio, which incurs transactions costs. As well, it may not be possible to add or delete stocks at the same prices recorded for the index basket.
Some ETF companies may offset tracking errors through security lending, which is the practice of lending out ETF holdings to mainly hedge funds for short selling. The lending fees collected from this practice can be used to lower tracking errors, if so desired (many ETF providers keep substantial portions of the lending fees for themselves).
