TRACKING ERROR: When the worm turns

There is evidence of a greater focus on exchange traded funds’ tracking error. Nick Fitzpatrick considers how some ETFs may be less faithful to the index return than others.

In the past three years, some of the innovative financial products that once sat like tasty fruit in a provider’s shop window turned rotten. Liquidity funds were a case in point when some of them were found to invest in highly risky assets related to the sub-prime mortgage market rather than just putting their money into safe bank accounts that offered good rates of interest with easy access.

The gremlins of complexity and opacity – which are sometimes conflated and confused with “innovation” – were largely to blame for tarnishing certain financial packages.

ETFs have come through the crisis intact, but the scrutiny of them has increased more or less in line with the outlandish growth of the European product offering.

Investors are taking no chances and an outwardly simple and straightforward product needs to be dissected relentlessly, it seems, for possible hidden nasties within, such as counterparty risk.

Closer attention
Another concern for ETF users is tracking error, which is the difference between the ETF’s performance and the return from the underlying index that it passively tracks. Research by Edhec Risk Institute found that the percentage of ETF users who employ more advanced ways to measure tracking error is growing. In 2009, 13% of respondents to an Edhec survey used more advanced measures of tracking error, while in 2010, 24% of respondents did so.

The numbers are statistically significant, Edhec says, and suggest investors are paying closer attention to ETF tracking error.

The importance of tracking error is that it reflects the overall quality of an ETF, says Matthieu Guignard, head of ETF product development at Amundi, the eighth largest provider in Europe.

“There can sometimes be large differences in the returns between different products, issuers and replication methods compared with the indices they are meant to track.”

ETFs based on the Euro Stoxx 50 index experienced tracking error ranging from 2.27 (Source’s Euro Stoxx 50 ETF) to 5.87 (State Street’s SPDR Stoxx Europe 50). (See table).

The Morningstar table also shows that there can even be differences in tracking error between products based on the same index from the same provider. The Source Euro Stoxx 50 Distributing ETF had a tracking error of 3.19.

The distribution of dividends in equity ETFs can be a cause of tracking error known as “cash drag”. The index value will reflect full dividend reinvestment, but ETFs that do not re-invest dividends will have this non-performing cash drag their returns.

“There are two types of index for equity ETFs: a total return index, which re-invests dividends on a daily basis; and a price return index, which keeps dividends in cash funds not exposed to the index,” says Guignard.

It has to be noted that tracking error is not an automatic guide to returns. Source’s ETFs – whether with the higher or lower tracking error – did not produce the highest returns of the peer group.

Manooj Mistry, UK head of db-x trackers, the third largest ETF provider in Europe, says the amount of duplicate products in Europe gives the issue of tracking error importance. However, he says it is more necessary to focus on the total cost of ownership. This is the spread between buying and selling an ETF coupled with the tracking effect and performance net of fees.

“Some products might have a low TER [total expense ratio] but their tracking error may be higher than other ETFs and conceals the benefits of a low fee,” says Mistry.

Found within the tracking error debate is the ongoing issue of index replication, or how an ETF is constructed. It boils down to which type of ETF – those that use swaps to track an index, or those that build an index from real securities – are the most efficient.

Swaps providers argue that their method is more efficient because swaps are more liquid. Liquidity is an issue with some products, such as those based on emerging market indices. For example, when an index needs to be rebalanced stocks have to be bought and sold quickly.

BlackRock’s iShares business, the largest provider in Europe, is predominantly a physical replicator. Axel Lomholt, Emea head of product development, says: “Tracking error doesn’t go away just because an ETF is swaps based. There exists a swaps spread – that is, the tracking error. If you look at an index and the swap spread is 30bps, that is the tracking error.”

Mistry says: “Physical replication is fine for mainstream indices, but for emerging markets and alternative strategies the synthetic [swaps-based] approach is more efficient.”

Although swaps may provide a more efficient way of rebalancing, Mistry points out that re-balancing can “catch out” swaps-based ETFs too. “We try to avoid products that have illiquidity,” he says, adding that this is one reason db-x trackers has not entered the high-yield bond market.

$351.5m (€246.6m) of net new assets flowed into European high-yield ETFs in the first quarter of the year, while money flowed out from government and emerging market bond ETFs, according to BlackRock.

Lyxor Asset Management, the second largest provider in Europe, launched the iBoxx Eur Liquid High Yield 30 fund in January on the London Stock Exchange. As the name suggests, it targets the more liquid section of the high-yield bond market, and like all its ETFs, exposure to the index is gained using swaps.

“The high-yield ETF is very liquid. Tracking error is very tight,” says Nizam Hamid, head of ETF strategy at Lyxor.

The fund’s prospectus says that the tracking error calculated over 52 weeks is less than 1% and that if the tracking error exceeds 1%, the objective is still to remain below 5% of the volatility of the index.

Robeco, the fund management firm, last year put high-yield bond ETFs under the spotlight by saying the product is not a low-cost, low-tracking error alternative to the Robeco High Yield Bond Fund. It based its research on three high-yield ETFs in the United States offered by State Street, iShares and Invesco’s Powershares business, which are benchmarked against various high-yield cash bond indices.

After examining tracking error, Robeco’s Partrick Houweling, senior quantitative researcher, said in a report: “Clearly, the ETFs do not live up to their promise, because their tracking errors are substantial, ranging from 7.3% to 12.0%. Moreover, they are higher than the tracking error of 6.3% of the actively managed Robeco’s HBF, whose tracking error is up to 50% lower than that of the ETFs.”

What does Lyxor’s Hamid make of this? He says this could be down to price discovery. Because bond pricing is not transparent, the ETF has to track the best estimate.

“[The report] seemed to misunderstand that ETFs were providing better, more transparent price discovery than the underlying market, which was opaque. The fixed income market does not have very good price discovery and many are traded OTC [over the counter],” he says.

Whatever the case, it is a sign that ETF providers may have to defend their records on tracking error. The importance of tracking error for their clients may vary, though the French financial regulator requires providers to publish records of it.

Respondents to the Edhec survey use methods such as correlation analysis to check the tracking quality of their ETFs. Some respondents use such advanced measures of tracking error as the “asymmetric or downside tracking error, or co-integration analysis”, the survey showed.

But 10% of respondents said they did not know what method was used. Edhec said this may be the result of the assumption that the tracking quality of these instruments is good. If that is the case, it seems that to some investors even the global financial crisis was not enough to deepen their scepticism for financial products.

©2011 funds europe



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