Investors are left with providers' 'self-serving' methodologies when it comes to calculating tracking error in exchange-traded funds (ETFs), Morningstar warns, adding that a harmonised approach would be beneficial.
In its latest report, entitled Measuring Tracking Efficiencies in ETFs, the data provider calls for a harmonised approach beyond the definition already provided by the European Securities and Markets Authority.
The regulator published the official translations of the Guidelines on ETFs and other Ucits issues in December last year. It had started looking into the operation of Ucits in summer 2010 to identify the possible impact on investor protection and market integrity.
“In the absence of a standard methodology for tracking error, the choice of calculation will be, in many cases, left at the discretion of the provider and investors will be forced to compare numbers across funds based on different and sometimes self-serving methodologies,” the report says.
Therefore, Morningstar proposes an alternative approach to measuring ETFs tracing efficiency for buy and hold investors. Its estimated holding cost metric, for example, aims to measure the realised performance of an ETF relative to its benchmark, considering all holding expenses and revenues.
Contrary to popular belief, Morningstar says high tracking error does not necessarily equal poor performance. Though there is a relationship between tracking difference (the difference in return between the ETF and the index) and tracking error (the volatility of that difference), its research suggests that it is not a particularly strong one.
Reiterating earlier studies, Morningstar says the most predictable and easily quantifiable factor affecting a fund’s performance relative to its benchmark is in fact the total expense ratio.
The report was compiled by Ben Johnson, director, global passive fund research, Hortense Bioy, director, European passive fund research, Alastair Kellett, international ETF analyst, and Lee Davidson, ETF analyst.