There was an interesting article in today’s WSJ about a recent report issued by Morgan Stanley on how the tracking error between exchange-traded funds and their prospective indexes increased last year:
Last year, 54 ETFs showed tracking errors of more than three percentage points, up from just four funds the prior year. And a handful of the 54 missed by more than 10 percentage points.
Nearly all exchange-traded funds, which are baskets of securities that trade all day like stocks, are designed to track indexes. So investors expect returns to closely mimic those of market gauges like Standard & Poor’s 500-stock index or the Barclays Capital (formerly Lehman) U.S. Aggregate Bond Index.
The article also mentions that the average tracking error for ETFs was 1.25% in 2009over twice the .52% average in 2008.
For those of you who don’t know, tracking error is the difference in returns (both positive and negative) between an investment vehicle and the index it tracks. Sometimes the investment outperforms the index but it’s much more common for the investment to underperform due to fund expenses. The difference in performance can also come from how the ETF is set up. According to the article, if the ETF buys every stock in the index, then its trading costs can be higher. If it buys fewer stocks in order to just represent the index, then it can become more vulnerable to tracking error.
The article doesn’t mention how many ETFs were studied and I can’t find a copy of the report. If anyone finds a link to the report, please send it my way. I’d like to check it out.