Tracking error, the amount by which an ETF's returns deviate
from its benchmark index, is a fact of life and an often ignored
fact at that. In some instances, a high tracking error can be a
good thing if it means the fund is far outpacing its benchmark.
The other side of that coin is that an elevated tracking error is
negative if the fund is lagging the benchmark index by a wide
Along those lines, classifying tracking errors as "high" and
"low" depends on the ETF's returns. A fund with a tracking error
of 50 basis points might appear to be diverging too much from its
benchmark, but if that ETF is up 10 percent, tracking error
clearly is not a big issue. If that same ETF only returns three
percent or four percent with tracking error of 0.5 percent, then
it is fair to say the fund is home to high tracking error.
In a perfect world, all ETFs would have tracking error
resembling that of the SPDR S&P 500 (NYSE:
). SPY is not perfect, but it is close. Over time, the fund has
done an excellent job of tracking the S&P 500 with the only
difference being the low 0.0945 percent in fees SPY charges
as data from State Street indicate
However, the world is not perfect and there are plenty of ETFs
with high tracking error. Here are a few examples.
SPDR Barclays Capital High Yield Bond ETF (NYSE:
ETFs tracking high-yield debt are often viewed as fertile ground
for elevated tracking error and that scenario is not limited
to corporate debt
One reason tracking error can be high in ETFs such as JNK is
corporate bond ETFs, investment grade and junk, usually have high
rates of portfolio turnover. There are costs associated with that
turnover. With JNK, there are a couple of factors that may be
impacting its tracking error. The fund holds slightly more issues
than its index and that marginally trims the ETF's modified
adjusted duration compared to to the index.
That probably is not the sole determinant, but this much is
clear: JNK will celebrate its fifth birthday next month and in
that time the ETF is up just over seven percent. Its index is up
more than 10 percent,
according to State Street data
iShares MSCI Brazil Index Fund (NYSE:
EWZ, the largest ETF tracking Latin America's largest economy,
has been a stellar performer since coming to market in July 2000.
No one can argue with that given that EWZ has nearly quadrupled
since then. To be precise, EWZ is up 288.2 percent since
The problem is the MSCI Brazil Index is up more than 361
percent over the same time, giving EWZ an annualized performance
difference of almost 1.6 percent,
according to iShares data
Investors should note tracking error can arise in emerging
markets ETFs due to some funds being home to thinly traded
components or liquidity issues in the market the fund tracks. EWZ
is an interesting case because the fund is proof positive that as
a developing market becomes more accessible to investors, the
ETF's tracking error can diminish. Over the past three years,
EWZ's annualized performance difference is
less than two-thirds of a percent
Market Vectors High-Yield Municipal Index ETF (NYSE:
As was noted with JNK, any high-yield bond ETF can prove
susceptible to tracking error. In the case of the Market Vectors
High-Yield Municipal Index ETF, one of the primary reasons for
the fund's tracking error is holdings. As in the ETF holds 285
high-yield muni issues, but its index holds 5,204.
HYD's index is up 14.6 over its life span, but the ETF is up
almost 14 percent since inception in February 2009. More
recently, HYD's tracking error has played in investors' favor,
perhaps indicating extracting a small number of bond issues from
a massive index can be profitable when executed well. Over the
past year, HYD's net asset value has topped the index by over 170
basis points. Year-to-date, the spread is 200 basis points.
Over narrower time frames, the spread is narrowing. In the
past 90 days, HYD's index has topped the fund's NAV by less than
15 basis points and over the past month, the ETF and the index
all essentially even.
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