Many can point to brokerage commissions and annual expense ratios as clear and defined fees to investing in exchange traded funds. However, there are also indirect costs to trading ETFs, such as tracking errors.
In a perfect world, investors would assume that a passive ETF would perfectly reflect the returns of the underlying index, sans the expense ratio. However, this is not always how it plays out.
For instance, the widely monitored the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) has been falling behind its underlying benchmark’s performance, reports Lisa Abramowicz for Bloomberg.
According to Morningstar data, JNK is up 4.32% year-to-to-date, while the underlying Bloomberg Barclays Very Liquid High Yield TR USD Index is 5.14% higher. Over the past five years, JNK has generated an average annualized return of 4.56%, whereas the underlying index showed an average 5.93% return.
However, investors should note that the tracking error has been tightening in recent years as State Street has taken steps to reduce the gap. In a call with ETF Trends, Matthew J. Bartolini, Head of SPDR Americas Research at State Street Global Advisors, said that SSGA has behind scenes improved the way the operation works through people, the process itself and implementation of technology since February 2016. SSGA committed greater resources, including expanding the capital markets team and added another PM, to better manage rebalancing in creations and redemptions. The additional resources has better control over indiosyncratic risks. Additionally, the team has access to better technology to help bridge the gap.
This tracking difference is “the most under-rated piece of ETF due diligence that’s out there,” said Bloomberg Intelligence’s Eric Balchunas. “Your net cost is how much did you miss that benchmark by.”
Meanwhile, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG), the main competitor of JNK, has returned a slightly better average annualized 4.80% over the past five years, compared to an average 5.46% return for the benchmark Markit iBoxx Liquid High Yield TR USD Index.
The slightly better or less worse tracking error found in HYG may be a contributing factor to its growing success. HYG has seen assets surge by 50% since August 2014, compared with the 25% growth in JNK’s assets under management.
Related: Don’t Overlook Junk Bond ETFs to Help Meet Income Needs
Industry experts attribute tracking error to how ETFs are constructed, or “optimizing.” ETFs employ a type of sampling technique that only picks certain securities from an index. Fully replicating an index is not always practical, especially in less liquid markets and hard to access areas, such as the notoriously illiquid speculative-grade debt market.
For more information on the fixed-income space, visit our bond ETFs category.
UPDATE: added additional information from State Street Global Advisors.