ETF Tracking Error Is Sometimes a Necessary Evil | ETF Trends

Logically, exchange traded funds (ETFs) should have minimal tracking error. That’s because they track an index, and in theory, if the index zigs, so does the ETF – and vice versa. It’s not always the case, though, and tracking error does occur.

Tracking error is defined as the difference between an ETF’s return and that of the index it’s supposed to be tracking.

Some ETFs are better than others when it comes to this, reports Lauren Young for Business Week. In 2007, several funds had a tracking error of greater than 300 basis points, not including expenses:

  • Vanguard Telecom Services (VOX): 478 basis points
  • iShares MSCI Emerging Markets (EEM): 408 basis points
  • PowerShares FTSE RAFI Utilities (PRFU): 338 basis points
  • PowerShares Water Resource (PHO): 285 basis points
  • PowerShares FTSI RAFI Consumer Goods (PRFG): 278 basis points

How does it happen?

ETFs that track large indexes, such as the S&P 500, rarely stray far from them, according to Business Week in a 2007 article.
That’s because those indexes hold widely owned stocks that aren’t
difficult to trade. Once an ETF goes "niche" and tracks an obscure
index, things change. Some asset classes are less liquid than others,
including small-cap international, emerging markets and small-cap
emerging markets.

The big factor in tracking error, Vanguard Sales Executive Ryan
Chaplinski told us, is index optimization. Optimization is done when,
for any number of reasons, replication is not possible: it would be too
expensive to buy the index, there are limits on the number of shares a
fund can own, the index is just too big and so on.

When a fund optimizes an index, "You open yourself up to tracking
error," Chaplinksi says. For example, he says if someone decided to
optimized the S&P 500 and only bought 400 of the 500 stocks, and
one of the 100 you didn’t own did extremely well, "you could fall

A rift is developing in the ETF industry, according to Index Universe for Seeking Alpha, between ETFs that use optimization to track indexes and those that use replication. The iShares Emerging Markets (EEM) and the Vanguard Emerging Markets (VWO) are
two examples of the battle. While both funds track the same index – the
MSCI Emerging Markets – they’re constructed differently. EEM uses an
optimization technique and currently holds 350 of the more than 800
stocks in the index. VWO replicates it in full.

The index returned 39.4%. For 2007, as you can see above, EEM
trailed its benchmark by 408 basis points and posted NAV returns of
34.6%, while VWO returned 39.1%.

Those in the industry who optimize defend it as cost effective and
say that over time, it should minimize variations from the index,
Chaplinski says.

In the case of the Vanguard Telecom Services, the fund had no choice
but to be optimized because the IRS limits investment in any one
security at 25% of a fund’s total assets. The telecom sector is
dominated by AT&T, he says, so owning the stock in exact proportion
would be impossible.

"The problem with that sector is that if we tried to replicate the
sector, we’d no longer be diversified. We can’t own all the AT&T
stock," Chaplinski points out. AT&T (T) had a great year in 2007 – up 20.6%. Having fewer of those shares gave the fund a wide deviation from its index.

"Because we didn’t own as much, we trailed the performance of the
benchmark. It could easily work the other way," says Chaplinski.
"There’s no way to get around it being such a huge part of any

Over time, he says, the hope is that the fund is reflective of the
overall sector: some years it’s up, some years it’s down, but overall,
it conforms to the sector performance. "We haven’t made any decisions
to change our approach."

Morgan Stanley’s ETF research group leader Paul J. Mazzilli said in a Wall Street Journal interview
that as ETFs get more specialized, tracking error is likely to
increase. They’re going to be based on newer or less well-known
benchmarks that aren’t as easy to track.

Even though tracking error may occur on the upside or downside, ETFs still provide investors a great opportunity to invest in an index and know what they’re buying.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.