How do you know if an ETF is performing in the way it should and delivering the results you wanted?

 

How do you compare the likely future performance of different ETFs that track a common index?

 

Merely looking at its performance over the previous year may not reveal much because markets rise and fall regardless of how well an ETF does its job.

The measure used to assess the performance of an ETF is its ‘tracking difference’ which is one of the most important statistics to consider.

Most ETFs aim to track an index—i.e. they try to deliver the same returns of a particular index; tracking difference is the discrepancy between the performance of the ETF and the performance of the index.

 

1-Year Performance

 

ABC Index                                           8%

ABC Index Tracking ETF                 6.8%

 

Tracking difference                        -1.2%

 

 Tracking difference is rarely zero and in most cases the ETF performance is poorer than the index it tracks; tracking difference can be small or large, negative or positive and are caused by the following factors:

 

Total Expense Ratio

  

The total expense ratio (TER) of an ETF is best indicator of future tracking difference. If an ETF perfectly replicates the performance of the index, the tracking difference will be exactly equal to the chare the issuer levies.

A fund that matches the index but charges 1% TER will have a tracking difference of 1%; therefore issuers compete to offer the most faithful replication with the lowest TER.

However, whilst it is a good indicator, TER is not the only consideration.

 

Transaction and Rebalancing Costs

 

Indices are reviewed and rebalanced on a regular basis and when a company joins or leaves an index the ETF tracking the index must buy or sell holdings accordingly.

The associated trading commission is paid with the fund’s assets which, increases its tracking difference.

ETFs that track indices with many holdings, illiquid securities, or those that rebalance frequently by design (e.g. an equal-weighted index) incur greater transaction and rebalancing costs, thereby increasing tracking difference.

 

Sampling

 

Some indices (especially bond indices) comprise thousands of components – some of which may be difficult to acquire at a fair price and it is therefore impractical to hold every single security; in this instance, some ETFs opt to hold a representative sample of the index.

In very large indices, the smallest securities have tiny weights and negligible impact on overall performance, so ETF managers may choose to exclude them in order to save on costs.

 

Cash Drag

 

ETFs may receive dividends from their underlying investments and these are periodically distributed to ETF shareholders.

However, there may be a time lag between the receipt of a dividend and its distribution – known as ‘cash drag’.

Investment managers may choose to temporarily reinvest those dividends, but those reinvestments also have associated costs; depending upon whether the ETF holds part of its portfolio in cash or pays to reinvest it will deliver slightly different returns, and therefore tracking difference than if the fund were fully invested.

 

Timing

 

When an index changes its components or rebalances, the changes are instant.

By contrast, an ETF tracking the index must go out and buy and sell stocks in order to realign itself with the ‘new’ index.

Price movements in the underlying securities that occur during the process of buying and selling may create a tracking difference between the index and the ETF.

 

Securities Lending

 

Some ETFs lend (for a fee) the securities in their portfolio to enable borrowers to take a short position – i.e. bet against a stock by selling it and hoping to buy it back cheaper, return the stock to the ETF and pocketing the difference.

This creates additional revenue for the ETF which can help reduce the costs of the ETF and improve its tracking difference.

Revenue generated from securities lending depends on prevailing capital-market lending rates; heavily shorted securities typically command higher premiums and can generate significant securities-lending revenue, others may be relatively insignificant.

 

 

Summary

 

 

There are many factors that affect how well an ETF reflects the returns of its underlying index.

Tracking difference is the best tool an investor has for assessing how all these factors interact and how well the ETF delivers on its promise to deliver the performance of the index it was created to track.

A good place to start would be by looking for ETFs with a low—or even positive—tracking difference that has remained relatively stable over time.





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