For those of you not familiar with the 7Twelve Portfolio, I would suggest you start here:

• An Introduction to the 7Twelve Portfolio

• 10 Questions for Craig Israelsen, Author of “7Twelve”

• The 7Twelve Portfolio’s Performance for 2010

Of the ten ETFs, the worst at capturing the index’s return was the Dow Jones Technology Index Fund (IYZ), which captured only 91.48% of its underlying index. The average ETF captured 95.32% of its index’s return. NOTE: These returns are total returns but do not include transaction costs.

For more on tracking error, check out ETF Tracking Errors: Protect Your Returns from Investopedia.

Next, I’ll look at the performance of the indexes vs. their growth and value sub-indexes. Stay tuned…

NOTES: This portfolio assumes $1,000,000 initial investment with a 5% income withdrawal on December 31, 2009 for a net investment of $950,000. The portfolio also does not include trading costs.

The Vanguard REIT Index ETF is up over 24% year-to-date and now makes up 9.49% of the total portfolio.

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 2009—over 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.

The intial list is slim but I expect that new offerings will be added with time.

Domestic Equity ETFs

• Schwab U.S. Broad Market ETF™ SCHB – 0.08%
Offers diversified exposure across large-, mid- and small-cap U.S. stocks. Seeks investment results that track performance, before fees and expenses, of the approximately 2,500-stock Dow Jones U.S. Broad Stock Market Index(SM).

• Schwab U.S. Large-Cap ETF™ SCHX – 0.08%
Provides exposure to large-cap U.S. companies. Seeks investment results that track the performance, before fees and expenses, of the Dow Jones U.S. Large-Cap Total Stock Market Index(SM) made up of approximately the largest 750 U.S. stocks.

• Schwab U.S. Large-Cap Growth ETF™* SCHG – 0.15%
Provides exposure to large-cap U.S. stocks that exhibit growth style characteristics. Seeks investment results that track the performance, before fees and expenses, of the Dow Jones U.S. Large-Cap Growth Total Stock Market Index(SM), representing approximately half of the market capitalization of stocks in the Dow Jones U.S. Large Cap Total Stock Market Index(SM).

• Schwab U.S. Large-Cap Value ETF™* SCHV – 0.15%
Provides broad exposure to large-cap U.S. stocks that exhibit value style characteristics. Seeks investment results that track the performance, before fees and expenses, of the Dow Jones U.S. Large-Cap Value Total Stock Market Index(SM), representing approximately half of the market capitalization of stocks in the Dow Jones U.S. Large Cap Total Stock Market Index(SM).

• Schwab U.S. Small-Cap ETF™ SCHA – 0.15%
Offers exposure to small-cap U.S. companies. Seeks investment results that track the performance, before fees and expenses, of the Dow Jones U.S. Small-Cap Total Stock Market Index(SM), made up of approximately 1,750 U.S. small cap stocks.

International Equity ETFs

• Schwab International Equity ETF™ SCHF – 0.15%
Provides broad exposure to international large-and mid-cap companies in over 20 developed international markets. Seeks investment returns that track the performance, before fees and expenses, of the FTSE Developed ex U.S. Index made up of approximately 1,400 international stocks.

• Schwab International Small-Cap Equity ETF™* SCHC – 0.35%
Offers diversified exposure to international small-cap companies in over 20 developed international markets and seeks investment results that track the performance, before fees and expenses, of the FTSE Developed Small Cap ex U.S. Liquid Index made up of approximately 1,800 international small cap stocks.

• Schwab Emerging Markets Equity ETF™* SCHE – 0.35%
Offers diversified exposure to large- and mid-cap companies in over 20 emerging markets. The ETF seeks investment results that track the performance, before fees and expenses, of the approximately 740-stock, FTSE All Emerging Index.

It will be interesting to see if Schwab puts pressure on the competition to lower their ETF fees. It will also be interesting to see if Schwab somehow integrates these ETFs into their 401(k) offerings.

Related:

The Schwab Guide to ETFs

*Available in December

If a stock goes down 10%, it takes a return greater than 10% just to get back to the original price. To illustrate that point, take a look at this graphic:

So, if an investment goes down 10%, it takes a return of 11.11% just to get back to the original amount.

Now let’s say at the beginning of the year you were looking for a 10% return on your investment over the next year. But, on January 4th, you already found yourself down 10% on the year. What kind of return would you need to get so that you still received a 10% rate of return over the year? The answer is a whopping 22.22%!

Pretty amazing isn’t it? It will be interesting to see where some of those ETFs finish for the year.

Although the graphic doesn’t mention it, 15 ETFs are down over 10%.

This isn’t a fun way to start off the year.

To Lily’s excellent analysis, I might add that one thing I like about ETFs is that they can be sliced and diced (if slicing and dicing is your cup of tea) in ways that mutual funds cannot (read this post to see what I’m talking about), which can allow an investor to create customized portfolios.

So, if you’re interested in reading a comparison of index mutual funds and ETFs, check out The Honest Dollar. While you’re there, check out the rest of her posts. Her blog’s fairly new but I like what I have seen so far.