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Go For The Top Tracker, Says Lyxor

Written by Paul Amery

 –  February 08, 2013

In a new advertising campaign, Paris-based ETF issuer Lyxor stresses that its funds have “the power to perform in any market”.

“Four of Lyxor’s major equity ETFs delivered the best performance versus their benchmark index in 2012,” the firm says. “This proves that not all ETFs tracking the same benchmark index perform the same.”

Lyxor says its ETFs tracking the MSCI Emerging Markets, MSCI USA, EURO STOXX 50, and FTSE 100 indices did best over 2012 against their European peers. For each index, the peer group consisted of Lyxor’s ETF on a particular index and the four other largest European ETFs tracking the benchmark.

For investors seeking to invest in portfolios replicating these four emerging markets, Eurozone, US and UK equity indices, “our funds represent the most efficient way to gain exposure to these markets via an ETF”, Lyxor asserts.

In the case of the MSCI Emerging Markets index, for example, you’d have earned between 0.1 and 1.11 percent more in 2012 by holding Lyxor’s ETF than by owning competing funds tracking the same index from iShares, db x-trackers, UBS and Credit Suisse, according to the Paris-based issuer.

Measured against the index, the 2012 returns of the funds ranged from an underperformance of 0.87 percent from Lyxor’s ETF to a 1.98 percent underperformance by Credit Suisse.

Although ETFs’ ability to track their underlying indices is something that’s often taken for granted, in practice it’s much more difficult to achieve, say researchers at Morningstar in a new study of exchange-traded fund tracking.

In its study, Morningstar looked at both the tracking error (defined as the variability of an ETF’s return against its underlying benchmark) and the tracking difference (the extent to which a fund’s return departs from that of its benchmark over time) of 65 Europe-listed ETFs based on eight popular equity indices.

“Generally speaking, the ETFs we studied have done a very good job of limiting tracking error,” Morningstar concluded.

Those ETFs (“synthetic ETFs”) using derivatives contracts from a third party to track their indices tended to have lower tracking error than ETFs investing in the indices’ underlying stocks or bonds directly (“physical ETFs”), Morningstar found.

iShares, Europe’s dominant ETF issuer by assets under management, runs the vast majority of its funds as physical ETFs. Bank-owned issuers like Deutsche Bank’s db x-trackers and Société Générale’s Lyxor have historically used synthetic replication, with the parent banks providing derivatives contracts to the funds.

But while there were some differences in tracking error between physical and synthetic ETFs, the tracking difference over time between funds and their indices depended little on the replication method, Morningstar concluded.

And, as in the case of the five MSCI Emerging Markets ETFs cited by Lyxor in its new ad campaign, funds’ total expense ratios explained only part of their tracking difference from the underlying index, Morningstar found.

“We found that a fund’s total expense ratio (TER) is an important factor in determining its performance relative to its benchmark, but not the only determinant. Other factors such as securities lending income, cash drag, tax optimisation, rebalancing costs for physical ETFs and swap fees for synthetic ETFs can all impact a fund’s relative performance,” the researchers said.

(Those factors have been examined in depth in previous articles: here, here and here)

For synthetic ETFs based on the MSCI Emerging Markets index, swap fees explain why funds underperformed their underlying index by more than the stated expense ratio in 2012, Arnaud Llinas, head of Lyxor’s ETF and index business, told

“Over the last year the market price of the swap for tracking the MSCI Emerging Markets index has been around LIBOR+60 basis points. The index is quite a tough one to track for the banks offering swaps, so they reflect that in their pricing,” Llinas said.

But physical ETFs based on the same index also faced tracking headwinds in 2012.

Compared with Lyxor’s 87 basis point (bp) underperformance in 2012, iShares’ physically replicated MSCI Emerging Markets ETF lagged the index by 96 basis points and Credit Suisse’s ETF, also physically replicated, by 198 basis points.

The extra underperformance of iShares’ MSCI Emerging Markets fund in 2012 (over and above the 75 basis point total expense ratio) can be explained by “optimised sampling and names substitution,” a spokesperson for the issuer told

“The fund is physically replicated, and the mentioned performance difference [is accounted for] by the complexities and restrictions in accessing the underlying markets in a physical way,” iShares said.

Issuers of funds using direct replication to track their indices often “optimise” their holdings in less liquid markets, owning only a sample of the index securities and often substituting securities listed in offshore markets (so-called depositary receipts) for hard-to-access domestically listed securities from emerging market countries.

In 2009, in particular, some trackers of emerging market equity indices got their sampling and substitution policy badly wrong and had problems replicating their benchmarks: iShares’ US-listed EEM, the world’s largest emerging markets ETF at the time, fell short by over 6 percent, for example.

Changes in European fund regulation mean that passive funds’ tracking performance is going to be under much greater scrutiny in future.

ESMA’s new ETF guidelines, which come into force this month, require ETF issuers to publish their funds “ex-ante tracking error, including its target level” in fund prospectuses and “an explanation of any divergence between the target and actual tracking error for the relevant period” in annual and semi-annual reports.

Morningstar’s researchers point out that the industry still lacks a common standard for measuring both tracking error and tracking difference, and has suggested its own methodology for assessing tracking difference.

Meanwhile, one issuer has clearly decided that the new focus on fund tracking offers a commercial opportunity.

“Tracking difference, tracking error and fund liquidity are the key areas we’re focussing on as an ETF issuer,” said Lyxor’s Arnaud Llinas.

“Just as active managers focus on producing ‘alpha’ for investors, in the beta industry there are also opportunities for managers to add value.”

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