Last year may have been a breakout year for exchange traded funds (ETFs), but some ETFs did not perform as well as they should have. The disparity between ETFs and the benchmarks they try to reflect widened.
According to a study conducted by Morgan Stanley (NYSE: MS), ETFs veered away from their benchmarks by an average of 1.25% in 2009, a gap more than twice as much as the 0.52% average for 2008, reports Ian Salisbury for The Wall Street Journal. [Causes of Tracking Error in ETFs.]
Everyone focuses on the benefits of ETFs – transparency, low fees, intraday liquidity and so on – but if they fall short of their indexes, they lose their advantage over active mutual funds and ETFs that do track their benchmarks. As ETFs grow, it’s important that they perform as closely as possible to their benchmarks.
The tracking error is seen as a result of the recent proliferation of ETFs that target niche investments or areas where trading is less liquid. 54 ETFs had tracking errors of more than 3% and some even had more than 10% last year. For instance, the iShares MSCI Emerging Markets Index (NYSEArca: EEM) gained 71.8% in 2009 while the benchmark returned 78.5%.
Large tracking errors make fund values unpredictable at any given time. Still, funds that that underperform one year may outperform in the next – tracking error may occur in both the negative and positive direction. iShares portfolio manager Dina Ting says that “over the long-term, we’ve delivered on our objectives.”
ETF tracking error may also be a result of the makeup of a portfolio. Some ETFs include every stock or bond from a target index, but many bond ETFs hold a representative sample, which makes them more vulnerable to tracking errors. Other reasons tracking errors might occur is because of limits to a specific stock weighting within an ETF or the existence of hard-to-trade securities. [Tracking Error: What It Is and How It Happens.]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.