Exchange traded funds (ETFs) try to track the returns of their benchmark indexes, but at times, there will be some relatively small tracking errors that do occur in both plain vanilla and short and leveraged ETFs. But don’t let this deter you from the usefulness of ETFs as an investment tool.
Tracking error is the extent an ETF would skew from the target performance it is suppose to mirror, writes Marc Gerstein for Seeking Alpha. But why does it occur?
There will always be some disharmony when one factors in transaction costs, other fund expenses, rebalancing protocols or investing in a sector of an index. But in reality, tracking error tends to be trivial, especially when dealing with major benchmarks.
Leveraged ETFs have a “meaningful tracking error” because of derivatives that help them magnify a benchmark’s gains or losses. If there is a noticeable and persistent tracking error, the leveraged ETF will still perform in a way that allows an investor to effectively use this investment tool on a daily basis to correspond with one’s chosen strategy.
In looking at different leveraged ETFs, the likelihood for tracking errors grow as one switches from a normal leveraged ETF to double, or triple leverage. Should this discourage us from using double or triple short ETFs? It all depends on your risk, goals and personal preference. Tracking error is something simply to be mindful of when considering leveraged funds.
With short and leveraged ETFs, it’s the internal compounding over time that leads to tracking error. This compounding has been illustrated like this:
- On a double-leveraged ETF, a 20% loss on $1,000 results in a drop of $400. Compare this to a triple levered ETF, which generates a loss of $160 on the same 20% loss, or a hit of 4 times the initial loss.
- Now repeat this over 14 cycles of both ups and downs, and the end result is a loss of 43.5% – it is almost impossible to have gains and losses of exactly 20% every trading session, this is just to emphasis the mathematics behind these funds.
These ETFs do what they’re supposed to do – they just aren’t meant as buy-and-hold investments. And on a daily basis, they track just as they should.
Max Chen contributed to this article.
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.