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Tricky Tracking Questions

Written by Paul Amery

  
February 11, 2013 14:46 (CET)

According to Morningstar, European ETFs generally do a good job in limiting tracking error. But Morningstar’s researchers refrained from giving a thumbs-up to ETF issuers when it comes to tracking difference.

Tracking error—the risk of short-term divergence between a fund and the index it follows—matters most to traders in ETFs and those using them for hedging purposes.

For long-term investors—and I’m in that category—tracking difference is the key metric. You don’t want to buy what’s sold as an index-tracking ETF and then find it’s underperformed the index by much more than its stated fees.

Morningstar looked at the annualised tracking difference of a selection of ETFs tracking eight widely followed equity indices over 2010-2012. The researchers found:

  • 12 ETFs tracking the Euro STOXX 50 index, with an average total expense ratio (TER) of 19 basis points (bp), outperformed the index by an average 47 bp a year. The top-performing ETF (ETFlab) returned 96 bp a year more than the bottom-performing (Source);
  • 10 ETFs tracking the FTSE 100 index, with an average TER of 33 basis points (bp), underperformed the index by an average 46 bp a year. The top-performing ETF (Comstage) returned 44 bp a year more than the bottom-performing (iShares DE);
  • 5 ETFs tracking the DAX index, with an average TER of 15 basis points (bp), underperformed the index by an average 23 bp a year. The top-performing ETF (ETFlab) returned 31 bp a year more than the bottom-performing (Lyxor);
  • 10 ETFs tracking the S&P 500 index, with an average TER of 19 basis points (bp), outperformed the index by an average 2 bp a year. The top-performing ETF (Comstage) returned 44 bp a year more than the bottom-performing (iShares DE);
  • 8 ETFs tracking the MSCI Emerging Markets index, with an average TER of 59 basis points (bp), underperformed the index by an average 95 bp a year. The top-performing ETF (iShares) returned 62 bp a year more than the bottom-performing (Credit Suisse);
  • 9 ETFs tracking the MSCI World index, with an average TER of 43 basis points (bp), underperformed the index by an average 26 bp a year. The top-performing ETF (HSBC) returned 45 bp a year more than the bottom-performing (Source);
  • 5 ETFs tracking the MSCI Japan index, with an average TER of 47 basis points (bp), underperformed the index by an average 49 bp a year. The top-performing ETF (Comstage) returned 17 bp a year more than the bottom-performing (Source);
  • 6 ETFs tracking the MSCI Brazil index, with an average TER of 64 basis points (bp), underperformed the index by an average 58 bp a year. The top-performing ETF (Amundi) returned 50 bp a year more than the bottom-performing (Source);

Here are a few conclusions that stand out for me from Morningstar’s research.

The main reason for the odd (at first glance) outperformance of ETFs tracking the Euro STOXX 50 and S&P 500 indices is tax. The index providers assume the maximum dividend withholding tax deduction from the shares in the index, while the ETF issuers can often earn more in practice (whether from securities lending, the use of derivatives or being based in a more favourable tax domicile). Whether they then credit the “earnings” from such activities to investors in their funds is up to them.

You can assume, judging by the dispersion of the fund returns, that some do and some don’t. The Euro STOXX 50 index, the most widely followed equity index for Europe’s ETF market, still offers rich pickings for those involved in the securities finance and delta one business.

As a reminder of the differences involved, last year the Euro STOXX 50 gross total return index returned 16.66 percent, while the net index returned 15.20 percent. European-domiciled UCITS funds wouldn’t have been able to achieve the full gross return, but they should all have been able to do better than the net index version. And most did.

Conversely, when a fund is tracking an index with much more limited or even zero opportunities for tax arbitrage (say the MSCI Japan or FTSE 100), then the dispersion of returns is smaller.

From a tracking difference perspective, it makes no difference whether you choose a fund using physical replication or one using derivatives. As Morningstar’s researchers point out, four of the top-performing funds in their study were physical, four synthetic. One might paraphrase this as saying that the opportunities to enhance returns (for example, via dividend tax optimisation) are ultimately the same for both types of ETF.

If you could choose between ETFs on the same index, wouldn’t you automatically go for the best performer? Not necessarily.

There may be investors looking to short the ETF. Extra, index-plus performance from the ETF adds to the cost of shorting.

And there are various ways of juicing the returns in the equity derivatives (or securities lending) markets that are not in the ETF investor’s best interest: for example, lending too much, dealing with lower-quality counterparties or taking worse collateral. Another might be the use of lower-quality sub-custodians in emerging markets.

For that reason, although for most investors extra returns are welcome, to me there are clear risks if we start incentivising ETF issuers to start behaving like active managers. Lyxor’s new ad campaign, in which it emphasises certain of its funds’ superior performance, could therefore be seen as a step in the wrong direction.

By forcing issuers to state upfront how they expect their funds to track in future, ESMA’s new UCITS guidelines should add some welcome clarity to the traditionally murky question of fund tracking.

But some tricky questions will remain for anyone analysing ETFs.

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