Here's how I know the ETF Revolution has long since passed, and
what we're living in now is the new ETF normal:The questions from
advisors are getting a lot smarter.
I used to get emails about how creation and redemption worked.
Now I get questions about tracking error.
Unfortunately, most people think about tracking error all
Here's a perfect example. Take two funds that have been in the
headlines a lot these past few weeks, the Vanguard MSCI Emerging
Markets ETF (NYSEArca:VWO) and the iShares MSCI Emerging Markets
Index Fund (NYSEArca:EEM).
Now imagine you're a Sophisticated Investor. You know a few
things:You know expense ratio matters. You know spreads matter. You
know tracking error matters.
So you pop up your Bloomberg, and here's what you see:
Even on trading, Vanguard wins on expenses. But Holy Meatballs
Batman, what are those guys down in Pennsylvania doing!? A tracking
error of 4.433 percent?
And at this point, many advisors will make a critical mistake,
assuming that the Vanguard fund is horribly mismanaged. It's not an
unreasonable assumption, if in fact this was an accurate tracking
error number. But it's not.
Remember, academic tracking error is the annualized standard
deviation of daily return differences. If the index is up 1 percent
today, and VWO is up 0.95 percent, well, that's -.05 percent to add
to the series. Take that whole series, plug it into your stats
package, get the standard deviation, annualize it, and there you
There are a few reasons this is all a terrible idea. First of
all, imagine that VWO was actually missing its mark by 0.05
percent, day in and day out. Well, the standard deviation of those
daily differences will be zero. It's enormously consistent.
Of course, if the index stayed perfectly flat all year, you'd
lose a cumulative 12 percent of your investment in that "perfect"
index fund. And because expense ratios are assessed daily, no
matter how big, it will never show up as "tracking error."
Second, "annualizing" a daily number is almost a useless
exercise. A 0.01 percent daily standard deviation would equal about
0.16 percent annualized. A 0.05 percent daily standard deviation
would give you about 0.79 percent over a year.
Neither of those figures actually has any bearing on whether
you'll be ahead of or behind your expected index returns, and since
almost all tracking error is mean-reverting, in both cases your
expected return likely centers somewhere around the index's return,
minus expense ratio.
In short, these kinds of tracking error measurements have
essentially no bearing on actual investor experience. What most
investors care about is holding period returns. So that's what we
look at here at IndexUniverse. We pose a simple question:What's the
difference between the index's return over the past year, and the
Grab that number for today, then go back to yesterday and get
the same one-year numbers. Keep doing that until you have a year's
worth of rolling returns, based on two years of data. Here's what
you get for these two funds:
Median Tracking Difference
Best/Worst 1-Year Difference
When we first started doing these calculations and presenting
them to folks a few years ago, we made the point of calling this
"Tracking Difference" to separate it from academic tracking error.
We got a lot of funny looks, but recently the Investment Company
Institute adopted precisely the same language, so we think it's
And what does it tell us? It tells us that your expectation for
any given year should be that VWO trails its index by about its
expense ratio (26 basis points vs. a 22 basis point expense ratio).
EEM will meanwhile actually beat its own expense ratio, trailing
the index by just 0.48 percent, which is likely due to good
However, with EEM, your range of expected outcomes is much, much
wider, from trailing the index by 1.22 percent to beating the index
by 0.52 percent. That's a pretty wide range of outcomes.
So purely from the "tracking" perspective, VWO gets the nod
here, exactly the opposite of what that "tracking error" statistic
So where does that big number come from? Accounting issues.
Vanguard, like quite a few ETF issuers, chooses to publish a "fair
value" net asset value (
). That means instead of taking the price of some South Korean
company after markets closed there, you adjust the price of that
company based on certain proxies such as how the currency has
moved, how futures have traded, and so on.
It's essentially what the market does all day with VWO-after
all, it will trade up or down even though most of its constituents
are closed for trading. It's not right or wrong-it's a fund
accounting choice, designed to get the NAV of the fund closer to
EEM makes a different choice-to publish a NAV more aligned with
how the index provider determines the level of the index. So on any
individual day, EEM will report a NAV that's much more closely tied
to the reported change in the MSCI Emerging Markets Index.
These kind of accounting issues pop up all over the ETF
landscape. Many international indexes mark all currency conversions
at 4 p.m. GMT. Funds that track those indexes often mark their
currency conversions at 4 p.m. Eastern time. If the currency moves
a lot in the intervening five hours, you can get wild swings in
In the bond markets, index providers and issuers can use
different pricing services, leading to apparent tracking
differences even if the fund holds precisely the same portfolio as
The moral of the story is simple:Always consider your
investments from your actual holding expectations, not just a
At the time this article was written, the author had no
positions in the securities mentioned. Contact Dave Nadig at
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