Investors typically focus on an exchange traded fund’s fee to gauge cost of long-term ownership. However, the way a fund provider manages the index portfolios may have a larger effect on an ETF’s performance.
“There are inputs and outputs on how you can gauge an index fund’s performance… but those metrics are not all equal,” Jim Rowley, senior investment analyst at Vanguard, told the Financial Times. “At the end of the day, what you are measuring is what is the fund’s excess return and what is its tracking error. Once you look at that, it’s, ‘What are the variables that cause those metrics to be realized?’”
Most analysts and investors typically look at easily quantifiable factors before investing in an ETF, including fund size, performance, expense ratios and trading costs.
However, Rowley contends that many do not distinguish the differences between inputs and outputs. Specifically, he points out that various sponsors may manage the securities withing an ETF differently, and the differences in the way ETF underlying holdings are fairly valued are statistically significant factors that can affect how an ETF’s returns may diverge from its benchmark, or affect an ETF’s tracking error to its underlying securities.
Notably, some providers may employ a sampling technique where an ETF would select some securities from a benchmark to serve as a proxy for the overall index. Consequently, new research from Vanguard and FlexShares found that the greater the difference, or so-called active share, between security weightings in ETFs and weightings in the underlying index would cause a greater divergence in returns between the fund and the index.
“What’s inside the portfolio or what’s inside the index is extremely important, especially as we [begin seeing]these less-well-known indices behind these ETFs, and each one looks at risk a little differently,” Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ, said in the FT article.
Both FlexShares and Vanguard help investors focus on the fact that portfolio management, even in passive index-based funds, can have a role in overall returns since the way a firm executes its index tracking methodology can impact tax efficiency and tracking errors.
For instance, Ed Rosenberg, senior vice-president and head of capital markets and analytics for the Northern Trust subsidiary, points out that a fund manager’s choice of securities to include in a creation/redemption basket can cause an ETF to outperform or underperform the target index. An ETF may exhibit greater short-term volatility, which can cause the fund’s performance to greatly diverge from the benchmark over time.
“If an investor looks at excess return and tracking error, that can help them answer the question: Did the fund meet their expectations?,” Rowley added.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.