The growing interest in indexing has led to the popularity of exchange traded funds. Several factors influence different funds to track the same index while generating varied returns and results.
“Although index funds and index ETFs seek to copy the composition and performance of an index, keep in mind that they are not identical to the index itself. After all, an index is merely a group of securities (or more accurately, the securities prices’ funneled through a math formula to provide a measure of the group’s performance),” Adam Zoll wrote in a recent Morningstar article.
There are many considerations that go into selecting an ETF, and some of these are the same factors that affect a funds’ overall performance.
Expense ratios are one of the biggest factors that affect a funds’ performance and the overall return that is generated. Since expense ratios eat into the principle of an investment, the cost is one of the most influential factors on ETF indexing performance. For example, two funds tracking the same index can end up with dramatically different returns if one is more expensive than the other.
Securities lending is also a factor in performance. Since cost can affect the performance of a fund, securities lending attempts to bridge the gap between the performance of an ETF and the index it tracks. The fund loans out shares to short sellers to raise capital to cover operating expenses, in turn, creating better tracking error.
Trading costs can also erode the overall performance of an ETF. Trading costs associated with brokerage accounts and frictional trading costs are culprits that eat away at returns. Brokerage commissions are a hidden fee when it comes to trading ETFs, and the more trades, the higher the costs become. Frictional costs come into the picture when ETFs adjust their portfolios to match an index. Investors bid up the price of the stock as the demand for it increases.
Tisha Guerrero 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.