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In Part One of this article, I developed a picture of how traditional
published expenses and less visible expenses—the
most important of those being transaction costs—adversely
affect fund performance. Now, let’s look at a useful framework
for analysis of these and other elements affecting fund performance:
Tracking error.
What Is Tracking Error?
Tracking error was not widely mentioned in investor
and adviser discussions of funds until a large number of
exchange-traded funds tracking multiple indexes were available
to investors. Index tracking had been discussed in connection
with index mutual funds, but the number of index
mutual funds was and is small, and the number of indexes
used by mutual funds is even smaller. It is useful to discuss
the growing interest in index tracking in connection with the
growth of index ETFs and then examine how a tracking error
framework can be useful in evaluating all types of funds.
Tracking error is one of a relatively small number of
financial terms that has been defined differently in different
situations. In most academic finance papers, tracking error
is defined as “an unplanned divergence between the price
behavior of an underlying position or portfolio and the price
behavior of a hedging position or benchmark.” 1 In these academic
applications, tracking error is usually expressed as the
expected or experienced one-standard-deviation annualized
percentage variation of a portfolio value from a benchmark
index value. This definition is used largely to measure how
much an actively managed portfolio strays from the benchmark
as the manager tries to add value. I will return briefly to
this definition later, but it is not the definition used in most
discussions of ETF tracking error and it is not the definition we
want to use as a framework for fund analysis and evaluation.
In discussing tracking error in the context of exchangetraded
index fund returns relative to the fund’s benchmark
index, the notion of a standard deviation would not be useful
before data for at least several years had accumulated.
However, “tracking” comparisons of ETFs are called for and
made when ETFs have been in operation for even less than
one year. The purpose of such early comparisons is simply to
measure how closely the exchange-traded index fund return
matches the return of the index. Most fund users neither
know nor care about standard deviations, so the comparison
fund analysts began publishing was simply the return of the
fund minus the return of the index. This difference is usually
expressed in basis points (hundredths of a percent) because
most index ETFs have tracked their index closely and the difference
is usually small.
When a standard deviation is used as the measure of
tracking error, the tracking error is always expressed as a
positive number. However, the difference between a fund’s
performance and the performance of its benchmark can be
positive or negative, depending on whether the fund performs
better or worse than the index. Understandably, there
was some confusion over the sign of a tracking error measure
until ETF analysts clarified what they were doing. The
tracking error measure used in connection with ETFs today
is positive when the fund’s NAV outperforms the index, and
negative when the fund under-performs the index.
As a simple example, if a fund return were +8.75 percent
for the year and the total return on its benchmark index
were +8.65 percent, the tracking error would be reported
as +10 basis points. If the returns were reversed, the tracking
error would be reported as -10 basis points. Calling this
difference “tracking error” seems reasonable and intuitive to
ETF analysts and users and it rarely confuses anyone except
finance Ph.Ds.
A few people have calculated a “tracking error” as the difference
between the market value return of the ETF and the return
of the index, but the most frequent comparison is between the
net asset value return of the ETF and the return of the index.
ETF market prices typically will converge on NAV over any long
period, making the long-term difference between the ETF market
value and net asset value negligible. While some comparisons
are done for shorter periods, the most widely discussed
ETF tracking error comparisons are annual.
Most ETFs have relatively low expense ratios; consequently,
there is not complete standardization on how the expense
ratio is treated in tracking error calculations. Some performance
tracking calculations add the fund’s expense ratio
back to the fund return on the theory that the fund manager
does not control these expenses. However, the expense ratio
comes out of the investor’s return and it seems appropriate
to compare funds uniformly after expenses. Consequently,
most tracking error comparisons do not add the expense
ratio to the fund’s return, but it is a good idea to check.
A number of index ETFs deserve extra attention because
they fail to track their benchmark indexes very well. There
are five principal reasons why an ETF will exhibit significant
tracking error by this performance difference measure. These
reasons are worth discussing because they account for most
high double-digit or triple-digit (in basis points) index ETF
tracking errors.
Non-RIC Or Non-UCITS-Compliant Benchmark Indexes
The U.S. Internal Revenue Code imposes diversification
requirements that investment companies in the United
States must meet to qualify as regulated investment companies
(RICs) for favorable pass-through tax treatment. RIC tax
treatment permits the distribution of interest, dividends and
capital gains to holders of shares in the investment company
without taxation at the fund level. In Europe, undertakings
for collective investment in transferrable securities (UCITS)
rules impose regulatory rather than tax diversification
requirements on funds.
The RIC diversification rules require that no more than
25 percent of a fund’s assets can be in the securities of a
single issuer except the U.S. government. Furthermore, with
respect to 50 percent of the assets of the fund, no more than
5 percent of the securities can be those of a single issuer,
again except for the U.S. government.
The UCITS requirements are structure rules, not tax rules,
and they are a little more complex than the RIC rules. Under
what is known as the 5/10/40 rule, a nonindex UCITS may
invest no more than 10 percent of its net assets in transferable
securities or money market instruments issued by the
www.journalofindexes.com January/February 2010
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