Tracking error on the rise

Advisers today can access more-exotic locales and asset classes than ever before, thanks to exchange-traded funds. The evolution of the ETF universe, however, means advisers need to be more aware of tracking error.

It’s usually an ETF’s expense ratio or its trading volume that gets the most attention when an adviser is choosing among similar ETFs, but how well an ETF actually tracks its underlying index should be an important consideration, as well, experts say.

“We think it’s a good measure of how the portfolio is managed and gives an indication of how much misfit risk you’re taking, relative to the underlying portfolio,” said Joel Dickson, a senior investment strategist in The Vanguard Group Inc.’s Investment Strategy Group.

In a logical world, an adviser could expect the return of a passively managed ETF to match the return of its underlying index, minus the expense ratio. An S&P 500 ETF that charges 10 basis points could reasonably have been expected to return 15.9% last year, 10 basis points less than the S&P gained. But that’s not always the case.

In fact, the average tracking error — the difference between an ETF’s return and its benchmark index’s return — is on the rise, mainly because of the expansion into more-exotic areas of investment, according to a recent study by Morgan Stanley.

The average ETF had a tracking error of 59 basis points last year, up from 52 basis points in 2011, according to the bank. Not only is the average tracking error increasing, so is the magnitude.

In 2012, only 39% of ETFs had a tracking error of less than their expense ratio, down from 53% in 2011. On the flip side, 14% had a tracking error of more than 100 basis points, up from 10% the previous year.

Some of the worst offenders last year were the $6 million iShares MSCI Emerging Markets Financials ETF (EMFN), which had a 5.3% tracking error, the $40 million Guggenheim S&P 500 Equal Weight Utilities ETF (RYU), which missed its benchmark by 4.4%, and the $2.5 billion PowerShares Emerging Markets Sovereign Debt ETF (PCY), with a 2.3% tracking error.

Advisers might not have been too upset about the tracking error in the iShares and Guggenheim ETFs, since both actually outperformed their indexes by those eye-popping numbers. Experts warn, however, that those kinds of dislocations should still be a red flag — they’re likely not repeatable and if such an instance occurs again, it could just as easily be an underperformance.

Several things can contribute to tracking error, but the most likely culprit is optimizing.

When an ETF provider launches a new product, the first thing it has to decide is whether or not to do a full replication — buy every single security in the index — said Rene Casis, director in the iShares Index Equity Portfolio Management Group.

That isn’t always practical, especially in emerging markets, where the local indexes are still developing and transaction costs are high, and in fixed income, where some bond indexes include securities that rarely trade.

OPTIMIZED PORTFOLIO

In those cases, the ETF provider usually will pick an optimized portfolio of stocks that should behave similarly, although not in perfect correlation, to the underlying index.

If, or more likely when, those chosen stocks happen to behave differently than the index — that’s where the dislocation occurs.

ETF providers have several tools at their disposal to combat tracking error, most notably securities lending. ETFs can loan their underlying shares to borrowers, primarily short-sellers, for a profit of about 40 basis points, according to research firm Markit Group Ltd. That can help an ETF outperform its expense ratio.

Over the past three years, for example, the $20 billion iShares Russell 2000 Index ETF (IWM) has had an annualized return of 12.23%, just 2 basis points lower than its underlying index, even though it charged 20 basis points.

Not all ETF providers share the bounty from securities lending equally, though. BlackRock Inc.’s iShares unit, the largest ETF pro-vider, returns 65% of its securities lending profits to its funds. State Street Global Advisors and Vanguard, the second- and third-largest ETF providers, return 80% and 100% of securities lending profits, respectively, to their funds.