Tracking error, in varying degrees, is a natural occurrence in exchange traded funds (ETFs). In making a more informed investment decision, investors will need to understand why and how factors may cause ETFs to deviate from its underlying assets.
Morgan Stanley stated that standard measures of tracking error in ETFs may lead to an “incomplete and misleading picture, ” reports Chris Flood for Financial Times. Matthew Tagliani, head of ETF product for Europe and Asia at Morgan Stanley, commented that “despite its fundamental importance in fund selection, the analysis of ETF tracking error remains a widely misunderstood and frustrating process for investors.” [ETF Tracking Error: The Exception, Not the Rule.]
The treatment of dividend payments is a major factor that affects how tracking errors are calculated for ETFs. Some ETFs may hold dividends as cash within the fund and pay it out later as distributions, but this process may produce tracking errors in the form of “cash drag.” [Coping with Tracking Error.]
Tagliani notes that the standard for measuring ETF tracking error underestimates the impact of fees and overestimates the impact of “noise” – timing delays, bid/offer spreads or other transitory factors – in trades, which would result in a consistent daily underperformance of an ETF compared to the benchmark. Additionally, outside factors such as trading restrictions or changes in taxation policies may create deviations between the price of an ETF and its net asset value.
The cause of disparity between the price of an ETF and the performance of the underlying benchmark is cost since fees will always be there to eat away from the fund’s returns, remarks Jessica Mead for City A.M. Other causes are less identifiable but may add together to amplify the effects. Benchmarks with illiquid constituents, benchmarks denominated in different currencies and statistical portfolio sampling techniques will all contribute to higher volatility and greater tracking error in ETFs, adds Mead.
For more information on ETFs, visit our ETF 101 category.
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.