Saturday, 19 September 2009

Some ETFs Don't Track Their Index Too Well

Investors like me who merely seek to replicate the returns of a broad index and not to time markets but merely passively track the index often use ETFs to do so. It's probably no surprise that ETFs vary considerably in how well they do the job of tracking the target index. The measure of the deviation from the index is tracking error.

Forbes' ETFs Behaving Badly article and accompanying 20 Best and 20 Worst slide shows describes results of a survey of 505 US-traded ETFs done by Morgan Stanley for 2008. In many of the worst cases the tracking error is several percentage points. The best have really tiny tracking errors.

Many of the worst trackers turned out to have out-performed or done better than the index in 2008. The article explains how some of those came about which gives me the sense that it's likely to keep happening. It's perhaps a nice accident that some results were better than the index in 2008 but in future years an uncontrolled or uncontrollable tracking error could well mean serious under-performance. Just give me the index please!

Most of both the best and worst lists are quite specialized ETFs. It's reassuring to see that among the best are Vanguard's Total US bond market ETF (BND) and iShares US TIPS Inflation-Indexed Bond Fund (TIP). A surprise is that some of the worst are several Vanguard offerings like their Energy Fund (VDE) and a Telecomms Fund (VOX) and an ETF heavyweight, iShares MSCI Emerging Markets Fund (EEM). There are also several bad country trackers, notably iShares' ETFs for Mexico (EWW) and Austria (EWO) and the SPDR S&P China fund (GXC).

3 comments: said...

Hi Jean, I think it's not so much of a surprise since the industry almost ubiquitously miscalculates tracking error (at least in its true sense).

From what I've seen and experienced, analysts are actually looking at absolute excess returns and not tracking error. So a low returning asset class will have an advantage due to the relatively little volatility and lower returns. Whereas more volatile and higher returning asset classes are harder to track.

For example if a bond index returns 1% and the ETF returns 0.5%, the absolute excess return is 0.5%, but is 50% on a relative basis.

With an emerging markets index, if the index returned 50% but the ETF returned 49% the absolute excess return was 1% but on a relative bases was 98%.

The emerging markets ETF would score poorly using the tracking error methodology that is normally used. But it is actually doing a better job of tracking.

More accurate would be to calculate the average of the standard deviation of returns as a proportion of the overall return, no?

If you did that, I bet you would find those Vanguard surprises would be quite tight in reality.

CanadianInvestor said...

Hi Preet, thanks for pointing that out. The gross absolute mretrun difference may indeed not be the best measure of ETF tracking quality.

Found this article at IndexUniverse which compares the Vanguard Emerging Market ETF VWO with EEM. VWO appears to be superior in that analysis too.

Jordan said...

If an ETF is allowed to lend securities then shouldn't it be possible for it to always beat it's own index?

I don't see how over performing an index is considered negatively as a tracking error. I would much rather see a list of "Badly behaving" ETFs that focused on the more concerning problem of under performance.

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