Comments on: One Bad Thing About Exchange-Traded Funds: Tracking Error

By: tobias s buckell

tobias s buckell — Tue, 23 Jan 2007 22:43:03 +0000

While index funds have some lag in being exactly like what they’re tracking, as someone who often recommends them instead of mutual funds as a better way of dabbling in stocks I’ll have to remember that as a caveat.

By: Jeremy

Jeremy — Fri, 19 Jan 2007 16:02:10 +0000

Index funds almost identically match the index they track. Typically the difference is about the equivalent of the expense ratio, which is typically under 0.25%. VFINX is a good example.

By: Angela

Angela — Fri, 19 Jan 2007 13:02:16 +0000

How well do mutual funds that track major indices perform in comparison? I imagine they have some tracking error caused by sampling so that might give you a better idea of what causes the difference?

By: Easy E

Easy E — Fri, 19 Jan 2007 00:35:47 +0000

Arbitrager, sounds like an easy job. How do I get it?

By: Jeremy

Jeremy — Thu, 18 Jan 2007 18:48:53 +0000

Rob, there is a lot of ETF arbitrage, but it is generally only for institutions. Without getting into too much detail it is this arbitrage that keeps the supply and demand somewhat in line so that the price doesn’t deviate wildly based on daily trading.

The basics of this arbitrage is summed up a bit by investopedia:

When the price of the ETF deviates from the value of the underlying shares, the arbitragers spring into action. If the underlying securities are trading at a lower price than the ETF shares, arbitragers buy the underlying securities, redeem them for creation units, and then sell the ETF shares on the open market for a profit. If underlying securities are trading at higher values than the ETF shares, arbitragers buy ETF shares on the open market, form creations units, redeem the creation units in order to get the underlying securities, and then sell the securities on the open market for a profit. The actions of the arbitragers set the supply and demand of the ETFs back into equilibrium to match the value of the underlying shares.

By: blbarnitz

blbarnitz — Thu, 18 Jan 2007 18:28:35 +0000

ETF tracking error can come from four possible factors:

1. Sampling error in those instances where an index is sampled, rather than replicated. Such tracking error is expected to be random, and in most instances, rather small. This is especially an issue with narrow international country specific ETF’s due to the diversification requirements of the 1940 Investment Company act which specifies the percentage limits of fund ownership in specific issues. Some countries markets are dominated by a few large stocks, which cannot be held by the index fund in market weights. Sampling error can be substantive in such instances. Total Market Indexes, which also are often sampled, produce very small sampling errors.

2. The ETF return will be reduced by B>expense ratio and transaction costs. These costs are usually quite low.

3. As exchange traded vehicles, ETF’s have spread costs, the difference in the price at which one can buy and sell the stock. Spreads should be narrower for highly traded, liquid ETF’s and wider for illiquid issues. The valuation of an ETF will be made at the lower sell price, since this is the price an investor would receive if the investment were converted to cash.

4.The discount/premium over NAV ETF’s usually trade at a narrow discount to NAV. These discounts and premiums are usually arbitraged by institutional investors whenever it is profitable to do so (after transaction costs). Once again, the discount/premium is usually lower for actively traded ETF’s than it is for more illiquid issues.

By: Rob

Rob — Thu, 18 Jan 2007 18:00:19 +0000

Although you would think that there would be some kind of arbitrage opportunity if the ETF shares didn’t accurately reflect the value of the underlying assets (not that I understand enough to know what that is), and that the market wouldn’t permit this.

By: Rob

Rob — Thu, 18 Jan 2007 17:58:30 +0000

I agree that market forces can affect the price of shares vs. the underlying asset value; it’s interesting however that all except one of the ETFs is LOWER than the expect NAV based on the index performance. It leads me to wonder whether there is some global depressing market effect for ETFs that mean you shouldn’t even expect to get the index rate of return. I am very interested in the answer to this question as well.

By: JLP

JLP — Thu, 18 Jan 2007 17:31:49 +0000

John,

I didn’t forget about management fees:

“And, even when I added back in the management expense ratio (most were .48%), two of the funds still captured less than 90% of their index’s return.”

By: John Forman

John Forman — Thu, 18 Jan 2007 17:25:05 +0000

We can’t forget the management fees involved in ETFs either. They have to contribute to negative variance against the performance of the index in some fashion.

That said, we also have to consider the value ETFs provide in terms of the liquidity and opportunity they offer to trader and investors who otherwise would not have the same opportunity to participate in the market.