ETF Tracking Error Fell In 2010, Study Says

About 68 percent of all ETFs had lower tracking errors in 2010 compared with 2009, even as expense ratios held steady, suggesting fund managers were running their portfolios more efficiently, according to a report from Morgan Stanley Smith Barney.

Tracking error on U.S.-listed ETFs fell to an average of 0.74 percentage point from 1.25 percentage points the prior year, Morgan Stanley said. When measured on a weighted-average basis, tracking error fell to 0.51 percentage points from 1.01 percentage points in 2009. Last year, the worst tracking error on record dropped to 5.84 percentage points from 17.1 percentage points in 2009, the report said.

Still, ETFs based on international indexes and fixed-income indexes can exhibit high tracking errors. Of the 28 ETFs with tracking errors over 2 percentage points, 18 were international ETFs. The fund with the worst-in-class 5.84 percentage-point (or 584 basis-point), error was the SPDR S&P Emerging Europe ETF (NYSEArca:GUR). One hundred basis points is 1 percentage point.

Tracking error is closely watched in the world of exchange-traded funds, because any lag comes out of investor returns. Tracking error is caused by:fees; optimization strategies involving sampling of underlying indexes rather than full replication; index changes; dividend reinvestment requirements; and legal aspects of the Investment Company Act of 1940 mandating how portfolios must be constituted.

Fund expenses as a percentage of weighted average tracking error increased to 62.8 percent last year from 31.7 percent in 2009. However, the weighted average expense ratio held steady at 32 basis points, clearly suggesting that managers did a better job managing their funds, the report said.

"Our study indicates that average tracking error was positively impacted by a broad improvement among ETFs," the report's authors, Michael Jabara, Stephen Minar, and David Perlman, wrote.


A few particularly large tracking-error declines in popular U.S. ETFs accounted for much of the decline last year.

For example, the SPDR Barclays Capital High Yield Bond ETF (NYSEArca:JNK) improved its tracking error from 1,299 basis points to 110-an improvement of 11.89 percentage points. Other large declines included the PowerShares Global Listed Private Equity Portfolio (NYSEArca:PSP), which fell from 1,368 basis points to 510, and the SPDR S&P Emerging Asia Pacific ETF (NYSEArca:GMF), which fell from 746 basis points to 58 basis points.

As ETFs struggle to compete in ever-more saturated markets, many have decreased their expense ratios to attract investors. ETF issuers such as Vanguard and Schwab have built their reputations by offering low-cost ETFs and have thus forced their competitors to offer cheaper products as well.

Most ETF issuers improved their tracking errors across all of their offerings. Guggenheim improved the most, although it also had the most potential for improvement. Vanguard's average tracking error was just 17 basis points, thanks largely to its ability to fully replicate most of the indexes it tracks.

Also, tracking errors on international and fixed-income ETFs showed strong improvement last year. They have historically been among the highest, due in part to lack of liquidity and because of sampling strategies.

Tracking error for international ETFs fell an average of 84 basis points to 110 basis points, the largest absolute year-on-year decline of any ETF segment. The weighted average tracking error for international funds was 104 basis points, a decline of 1.28 percentage points from 2009.

Also, tracking error on fixed-income ETFs fell by an average of 1.44 percentage points, or 144 basis points.

In contrast, the average tracking error for U.S. equity ETFs in 2010 was 57 basis points.

Tracking Errors Among Select U.S. ETF Sponsors, In Basis Points (bps)
Issuer 2010 2009 Decline
Guggenheim 102 bps 201 bps 99 bps
PowerShares 105 bps 178 bps 73 bps
Vanguard 17 bps 83 bps 66 bps
State Street 86 bps 142 bps 56 bps
WisdomTree 79 bps 129 bps 50 bps
Rydex 64 bps 105 bps 41 bps
BlackRock 49 bps 85 bps 36 bps

Sampling Hurts

ETFs attempting to track less-liquid markets generally have higher tracking error, since they often have to optimize, may have trouble mimicking index turnover and may not necessarily be able to reinvest dividends accurately.

Indeed, international ETFs accounted for 38 percent of the overall average tracking error and 57.9 percent of weighted average tracking error, while only making up 25.5 percent of the ETFs in the study.

"In general, US Equity market segments such as U.S. Major Market and US Style ETFs track their indices more closely due to lower expense ratios and [being] easier/cheaper to access underlying markets, which typically leads to lower fees and less optimization," the report said.

"Conversely, international and global ETFs are more likely to experience higher levels of tracking error as these ETFs continue to penetrate markets that are more difficult to access, which typically leads to higher fees, a greater need for optimization, and increased idiosyncratic risk."

As noted, overall tracking error for international ETFs fell by more than in any other ETF category.

The Morgan Stanley Smith Barney report surveyed all U.S.-listed ETFs with at least a year of trading history. It excluded active ETFs, static-basket ETFs, leveraged/inverse ETFs, physical commodity ETFs and currency ETFs.

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Copyright ® 2011 Index Publications LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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