ETFs Tracking Error

The tracking error of a fund is the annualized standard deviation of the differences in the daily ETF’s returns, based on its net asset value (NAV),  and the benchmark index returns. The ETF’s reported tracking error is useful to investors. It indicates the magnitude by which an ETF’s returns deviate from those of its benchmark over time.

Sources of Tracking Error

The following are the causes of the variation between an ETF’s expected and actual returns and the range of results relative to its index.

1. Index changes: ETFs track indexes and therefore need to follow suit when the indexes are updated. While updating, ETFs incur transaction costs, which are not always the same as those of the index.
2. Cash drags: ETFs have cash holdings, unlike indexes. The time lag between receiving the cash and reinvesting it potentially causes variance.
3. Expenses and fees: Index calculation generally assumes that trade is devoid of friction and occurs at the closing price. A fund’s operating fees and expenses reduce its return relative to the index.
4. Representative sampling or optimization: When the benchmark index comprises thinly traded stocks, an ETF provider can’t buy them without excessively increasing their prices. Therefore, it uses a sample that has higher liquid stocks to proxy the benchmark index.
5. Depositary receipts and other ETFs: ETF managers may choose to hold depositary receipts when the local market shares are illiquid. The trading hours and security prices vary. This causes a divergence of the fund value from the value of the benchmark.
6. Fund accounting practices: Fund accounting practices may differ from those of index calculation. For example, numerous fixed-income ETF portfolios value bond positions at the time of the equity market close, in line with the ETF industry custom. On the other hand, fixed-income indexes value bonds at an earlier time, in line with the bond market’s practice. Therefore, valuation discrepancies may arise between the ETF’s NAV and the index value.
7. Regulatory and tax requirements: Funds may be subject to regulatory and tax obligations that are different from those assumed in index methodology, such as foreign dividend withholding.
8. Asset manager operations: ETF issuers may attempt to offset costs through security lending and foreign dividend recapture. These act as “negative” costs, which enhance fund performance relative to the index.

Question

Which of the following sources of a typical ETF’s tracking error is most likely to contribute the least to the fund’s tracking error?

1. Fees and expenses.
2. Representative sampling.
3. Index changes.

Solution

The correct answer is C.

Index changes, which include additions and deletions of securities from the underlying benchmark index, occur infrequently. Besides, the ETF managers may work with APs to rebalance index trades to minimize this source of tracking error. Therefore, the tracking error arising from index changes is less likely to be as large as the tracking error due to representative sampling or expenses and fees incurred by the ETF.

Reading 39: Exchange Traded-Funds, Mechanics and Applications

LOS 39 (c) Describe sources of tracking error for ETFs.