Close But Not Quite Perfect: Common Sources of ETF Tracking Error By John Spence July 18, 2002

Exchange-traded funds allow investors to track indexes in real time, but for several reasons they can't provide perfect correlation. Differences in fund and benchmark returns may arise - here is a list of some of the more common causes.

1. Fees - Ah yes, indexers always start with the fees. Although expense ratios for ETFs are the lowest in the business, they still exist. The 101 domestic ETFs in Morningstar's database have an average expense ratio of 0.48%. ETF returns, or for that matter any fund's performance, are net of any fees. Simple enough.

2. Dividend reinvestment policy - Excluding HOLDRs, which are grantor trusts, ETFs have two basic structures: management investment company and unit investment trusts. Most ETFs use the management investment company (or open-ended) structure, which allows for immediate reinvestment of dividends. However, some of the earliest and largest ETFs, such as the SPDR Trust (SPY) and Nasdaq-100 "cubes" (QQQ), are unit investment trusts (UITs). UITs are less flexible than their management investment company cousins, but the UIT structure was chosen for the initial ETFs because it was inexpensive and didn't require a board of directors.

The bottom line is that UITs cannot immediately reinvest dividends - this type of structure distributes dividends to shareholders quarterly, which causes minor tracking error. Management investment company ETFs, on the other hand, can immediately reinvest dividends. Immediate reinvestment of dividends causes outperformance in a rising market and underperformance in falling markets.

3. Premiums and discounts - Generic ETF returns are typically measured on a monthly or yearly basis. At the market close at the end of the month or year, an ETF may trade at a premium or discount to the net asset value (NAV) of the underlying securities. This will lead to discrepancies in index and ETF performance. From a practical standpoint, however, ETF tracking error within an investor portfolio depends on premiums and discounts at the time when the ETF was bought and sold.

4. Optimized portfolios - In some cases it is inefficient for an ETF or index fund to hold every stock in a large index. For example, small and illiquid stocks carry steeper transaction fees. Therefore, ETFs such as Barclays Global Investors' MSCI EAFE iShares (EFA) and Vanguard's Total Stock Market VIPERs (VTI) hold a representative sample of the index. This is the "art" of running a passive portfolio - balancing costs with index tracking error. Also, ETFs have diversification requirements that index providers aren't required to follow. For example, ETFs cannot have more than 25% of assets in any one stock, and all the stocks in an ETF with a weighting over 5% cannot exceed 50% of the fund's total assets when combined.

5. Rebalancing - This is another area where passive managers earn their salt with savvy trading. When an index rebalances, an index fund or ETF is required to follow suit. However, the timing of the trades is at the discretion of the fund manager. How a fund manager deals with an index rebalance affects returns. For example, Vanguard index fund manager Gus Sauter and his team are renown for edging out index returns through opportunistic trading.

6. Time zones - Some international ETFs trade in the U.S. while the underlying markets are closed. Sometimes it appears that these ETFs are not trading close to NAV, but the reason is that a "stale" NAV is being used. The international market may have been closed for hours while the ETF trades in the U.S. In other words, this tracking error is perceived, not actual.

07/18/2002

References

• Index-Linked Exchange-Traded Fund Quarterly. Paul Mazzilli, Dodd Kittsley, John Duggan, Lorraine Wang, and Erin Kim. Morgan Stanley ETF Research Team, June 28, 2002.
• Exchange Traded Funds. Jim Wiandt and Will McClatchy. John Wiley and Sons, 2002.