The old adage that everything you read on the Internet must be
true took a major hit today, as a flawed tracking error study
that lend securitiesto those that do not made its rounds.
In the past two years, IndexUniverse has gone to great lengths
to ensure the data we use to analyze ETFs is both clean and
trustworthy. While that may seem like a simple endeavor, in reality
it has been a painstaking process that has cost us hundreds of
At the heart of our mission, however, was being able to
effectively and accurately measure ETF tracking error. In doing so,
we found it can be easy to misinterpret tracking differences. One
common mistake, which showed up in the blog post from the
Securities Litigation & Consulting Group, was that comparing
total return NAV to a price return index would produce misleading
Now, this is not an indictment of SLCG, per se. After all, some
issuers don't publish total return versions of their indexes. That
said, the majority of index providers do provide total return index
levels, so any study analyzing tracking error that does not compare
total return NAV to the total return version of the underlying
index will produce erroneous results.
Furthermore, there are some issuers who fair-value their NAVs
for ETFs holding international securities, which will cause the
published total return NAVs to deviate (sometimes greatly) from the
index. The cause of this is simple to understand:An index simply
reflects the prices (adjusted for distributions in the case of
total return indexes) of the securities it tracks, and when foreign
markets like, say, Hong Kong or Hanoi close, the index will not
update during the portion of U.S. market hours that those markets
Fair-valued NAVs, on the other hand, use a model to estimate the
price of the portfolio using things like futures, ADRs and highly
correlated securities. The reason issuers do this is to try and
dampen intraday premiums and discounts in the ETF market. This
disconnect will cause tracking differences to appear larger than
they (likely) actually are.
There is also another little-known quirk in indexing and NAV
calculation that can be easily overlooked that pertains to
international ETFs. There are some index providers that strike
their currencies at the local market close, while the issuer of
funds tracking those indexes strike their currencies during U.S.
market hours. This creates another potential wedge between NAV and
the index level that cannot be fully captured in a simple tracking
As such, any robust study of tracking error will need to take
all of these things into consideration in order to ensure you're
comparing apples to apples.
To get a true gauge of the efficacy of securities lending, I
went through the process of screening ETFs as described above.
First, I eliminated any funds that are not allowed structurally to
lend securities (unit investment trusts). Then I eliminated any
leveraged and inverse funds to eliminate as much noise as possible
from my study. Next I removed any ETFs that either fair-value their
NAVs or do not have a total return version of their underlying
indexes. Finally, I settled on a sample of funds that had more than
two years of history.
After I had my sample of 433 funds, I split them into funds that
lend portfolios securities and those that do not. Of those 433
funds, 287 lend securities and 146 do not. The table below shows
the results of my study after backing out the expense ratio for
Tracking Error for ETFs
No Securities Lending
|(Asset) Weighted Average
After accounting for expense ratios, ETFs that lend portfolio
securities did a demonstrably better job tracking their index. In
fact, ETFs whose issuers actively engage in securities lending
tended to claw back 5 bps over a one-year holding period. This
figure aligns well with the tracking difference when weighted by
ETFs that do not lend securities tended to lag their index by an
additional 9 bps beyond their expense ratio over a typical one-year
holding period. When you weight by assets, ETFs that do not lend
shares lagged their indexes on average by the same 9 bps. That is a
gap of 14 bps, a figure that may seem small but that will add up
quickly over time.
Once you get inside the numbers, there are some very interesting
takeaways. Some much smaller ETFs, like the iShares MSCI Emerging
Markets Financials Sector Index Fund (NYSEArca:EMFN), which has
just $7 million in AUM, had huge index outperformance stemming
either from very profitable securities-lending revenues or heavy
EMFN outperformed its index by over 4 percent on a median basis
over the past two years
accounting for its expense ratio. These outliers speak to the
challenge of trying to sequester the impact of securities lending
from other forces. Said another way, making concrete claims about
the impact of securities lending can be a fool's errand.
But that will not stop me from trying. A complete analysis of
the impact of securities lending should take into account all of
the things I listed above-TR index availability, fair-valuing of
NAVs and differences in foreign exchange rate strike prices-in
order to weed out any noise.
And that noise is likely all the data from the SLCG study shows.
Because the study compared total return to the price return, the
mirage of superior tracking from ETFs not lending securities was
likely a product of portfolio yield as opposed to any substantive
'outperformance.' As my nonno always told me, don't believe
everything you read.
At the time this article was written,
the author held no positions in the securities mentioned.
Contact Paul Baiocchi at firstname.lastname@example.org.
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