ETF providers last year got better at what they do, serving up
funds that more closely tracked the performance of their underlying
indexes, according to a Morgan Stanley study that found tracking
error across the U.S. ETF market has improved by 30 percent in the
last year alone.
The Wall Street bank said that year-on-year, nearly
three-quarters of U.S.-listed ETFs had lower tracking errors in
2011 than the year before, and only one in 11 funds had tracking
error of more than 1 percent. Tracking error is the difference in
total return between an ETF's net asset value (
) and its underlying index.
Tracking error across the 700-plus U.S. ETFs surveyed in 2011
averaged 52 basis points at the end of 2011-as much as 22 basis
points below the 2010 average, and a far cry from the 1.25 percent
average seen just two years ago. What's more, more than a third of
the ETFs surveyed kept tracking error below the 25-basis-point
mark, an improvement from a 1-in-4 ratio seen in 2010.
Tracking error is a key measure of just how good an index ETF is
at meeting its goal of replicating its benchmark's performance.
It's become increasingly important as ETFs canvass areas of the
market broad and narrow, providing a viable alternative to more
expensive active management. The Morgan Stanley study excluded
active ETFs, as well as leveraged and inverse funds.
"As a result of lower tracking error in 2011, 53 percent of ETFs
exhibited tracking error less than or equal to their expense
ratios," the company said in the report. "This is a constructive
development for ETFs."
Morgan Stanley noted that factors like fees and expenses of a
fund, optimization and diversification requirements, scale, access
to capital markets around the world, as well as index turnover and
dividend reinvestment policies can affect a fund's NAV relative to
"A higher ratio of expenses to tracking error corresponds to
more effective tracking of index performance," the company
Expense Ratios Are Key
Investors may not realize it, but what they pay in management
fees is counted as part of tracking error and, moreover, it's often
the single biggest source of tracking error.
It shouldn't come as any surprise, then, that
U.S.-equities-linked ETFs tapping into style and major markets
consistently show some of the lowest tracking errors because those
ETFs also have some of the cheapest price tags.
Most U.S.-equities-linked ETFs-from major market funds, to style
funds, to specific sector strategies-ended the year on average with
tracking errors of 35, 26 and 47 basis points, respectively.
AMLP:A Case Unto Itself
By comparison, U.S. equities ETFs with niche strategies that
invest in everything from a buy-write portfolio to clean energy as
well as long/short funds-had average tracking error of as much as
95 basis points, and were the only category of U.S. equities ETFs
that saw tracking error performance deteriorate in the last
Behind that performance shortfall was the biggest offender in
the tracking error game:the Alerian MLP ETF (NYSEArca:AMLP), an ETF
that serves up a portfolio comprising master limited partnerships
that also happens to represent more than 40 percent of total assets
in the "U.S. Custom ETFs" space surveyed, the report said.
AMLP ended 2011 with a tracking error of 695 basis points-nearly
7 percent off its benchmark performance, a number that helped skew
broader averages. AMLP's index returned roughly 17 percent, meaning
the tracking error knocked down actual returns to around 10
"The deviation in AMLP's NAV performance versus its index is
primarily the result of the fund's structure as a C-corporation,
which requires the fund to pay corporate income taxes on profits,"
the report said.
"This accounting treatment may cause AMLP's NAV to underperform
its benchmark in rising markets, such as 2011, or outperform in
Optimization A Culprit
Another culprit behind tracking error is optimization, when an
ETF opts to own some but not all of the securities in its index in
an effort to keep portfolio costs down and turnover low.
Optimization is frequently used by ETFs canvassing relatively
illiquid markets, which is why so many bond funds use sampling
Fixed-income ETFs had an average tracking error of 40 basis
points in 2011, an 18-basis-point improvement from the year before
and a five-year low.
That said, not all fixed-income funds are created equal.
Indeed, some bond funds, such as a lineup of Invesco PowerShares
ETFs, showed just how tricky it can be to achieve that perfect
track record in the fixed-income space. Bond funds like
PowerShares' PICB, PWZ, BAB and PHB each ended the year anywhere
from 147 to 233 basis points off their benchmarks.
BAB, for instance, is highly optimized, owning less than 3
percent of the securities comprising its BofA Merrill Lynch
It might come as no surprise that some of the widest tracking
errors came from international equities ETFs that often rely on
less liquid securities or turn to derivatives to access remote
regions of the global economy.
On average, international equities ETFs ended the year with a
tracking error of 68 basis points, according to data compiled by
The iShares MSCI Belgium Index Fund (NYSEArca:EWK), for
instance, ended the year 296 basis points off its index-EWK's NAV
dropped more than 15 percent in 2011 while its underlying benchmark
dropped by 12.2 percent.
Several other funds also crossed the 200-basis-point tracking
error mark. Among them, the SPDR S&P Russia ETF (NYSEArca:RBL),
which ended the year 210 basis points below its index.
Many Asia-Pacific funds, as well as most of the China-linked
ETFs surveyed, also struggled to keep their performance closely
tied to their underlying strategies.
The Global X China Industrials ETF (NYSEArca:CHII), for
instance, ended 2011 with a tracking error of 284 basis points,
while the SPDR S&P China ETF (NYSEArca:GXC)'s tracking error
hit 270 basis points.
As a group, funds that serve up exposure to Brazil also
generally missed their indexes' mark, many underperforming their
The NAV of the market's largest Brazil-focused ETF, the iShares
MSCI Brazil Index Fund (NYSEArca:EWZ), underperformed its index by
47 basis points last year, while a group of Global X Brazil ETFs
came in roughly 1 percent below their underlying indexes.
Positive Tracking Error
But not all tracking error is necessarily a sign of
In rare instances, some funds manage to outperform their
That was the case for the iShares MSCI Spain Index Fund
(NYSEArca:EWP), for instance, which ended the year 223 basis points
ahead of its underlying index.
The Market Vectors Egypt Index ETF (NYSEArca:EGPT) was another
fund where a nearly 2 percent tracking error average was in fact an
outperformance of its index. EGPT's NAV slid in 2011 by 49.8
percent while its benchmark dropped 51.7 percent.
Also, the iShares MSCI France Index Fund (NYSEArca:EWQ) ended
2011 with its NAV and index at the same level-a difficult-to-repeat
feat if there ever was one.
Providers Under The Microscope
From a provider standpoint, just about every ETF firm in the
U.S. market saw its tracking error average, in absolute terms, drop
in 2011 from previous years.
Which types of ETFs they offer as well as the costs associated
with those strategies are the biggest underlying factors
determining a provider's overall tracking performance, the report
Still, in 2011, the leading exception, as noted, was ALPS, which
averaged a tracking error of 216 basis points across its five ETFs
surveyed, the report said. Just a year earlier, the company's ETFs
averaged a tracking error of under 1 percent.
Other companies such as Pimco and U.S. Commodity Funds also
ended the year with slightly higher tracking error averages than
they did in 2010.
But companies like Emerging Global Shares narrowed the
performance gap last year, ending 2011 with an average absolute
tracking error of 77 basis points, compared with a 221-basis-point
average a year earlier. EGShares is behind 19 ETFs.
Some of the largest players in the ETF industry, such as
BlackRock and State Street Global Advisors, also showed
consistently improving tracking performance.
BlackRock, parent of the world's largest ETF provider iShares,
averaged 40 basis points in tracking error last year, down from 49
basis points a year earlier and 85 basis points in 2009. The
company has more than 250 ETFs on the market.
SSgA meanwhile ended the year with an average tracking error of
46 basis points across its 85-plus ETF platform-significantly lower
than its 142-basis-point average just two years ago.
Vanguard, the quickly growing low-cost ETF provider behind more
than 60 ETFs, came in with an average tracking error of 17 basis
points, unchanged from 2010, but a significant improvement from its
average of 83 basis points in 2009.
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