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indexes is an unfortunate decision, usually made by the fund
issuer. Fortunately, it is easy for an investor to avoid funds
that are based on noncompliant indexes and that, consequently,
conceal the quality of their portfolio management
process. If you already own shares in a non-RIC-compliant
index fund and prefer not to change, suggest to the fund’s
manager that they consider changing to a RIC-compliant version
of the index.
Optimized Portfolios Designed
To Reduce Trading Costs
Many ETFs based on a large number of stocks such as U.S.
total market funds and multicountry funds often have portfolios
that are optimized or sampled to reduce custodial costs
and the administrative costs involved in handling a creation
or redemption basket that might otherwise include as many
as several thousand securities. While there is no universal
pattern for optimized portfolios, they often underweight
the smaller-capitalization stocks in the index. If small-caps
are underweighted, the fund will outperform the benchmark
when the small-cap components under-perform the balance
of the index. When small-cap stocks outperform the large-cap
stocks in the benchmark, the optimized fund will under-perform
the benchmark. Some issuers of funds with a large number
of issues in their benchmark resort to completion baskets
or completion swaps covering the small-cap portion of the
portfolio to improve tracking while simplifying fund management
and reducing the cost of creation and redemption.
Small And Illiquid Index Components
A number of backtested “concept” indexes have been
designed solely to serve as ETF templates. The resulting ETFs
are often sold based on a combination of good backtested
performance and an investment concept that suggests rapid
future growth. The indexes—and the ETF portfolios—often
include some small and illiquid issues. If the backtested fund
succeeds in attracting substantial assets, the portfolio manager
may—for reasons that include (1) the risk or difficulty
of trading large positions in illiquid stocks, and (2) position
reporting requirements—decide not to increase the fund’s
position in a small company beyond 5 or 10 percent of the
company’s outstanding shares as the assets of the ETF grow.
If the portfolio manager does not hold shares in these positions
at the index weighting, the performance of the fund
will diverge from the performance of the index.
The Lazy Portfolio Manager
Lazy portfolio managers are probably the greatest single
reason for index fund tracking errors that are consistently
more favorable (positive) when the market is weak, and
unfavorable (negative) when the market is strong. One of the
important differences between investment company ETFs and
mutual funds is that the ETF portfolio manager does not need
to hold cash balances to meet cash redemptions. The ETF
portfolio manager who wants to manage cash aggressively
can be invested down to the fund’s last few dollars each day
without any unusual cash flow management problems. In fact,
however, many ETF portfolio managers do not invest their
cash aggressively. Many funds show a pattern of returns that
suggests the manager consistently holds excess cash. During
years when the market rises, these funds lag the performance
of their benchmark index because interest on cash balances is
not keeping up with the return on positions in the index. The
same index funds will look too good to be true in a year like
2008 when their cash balances earned modest positive returns
while portfolio positions performed poorly. In retrospect, a
cash balance would not have been a bad idea in 2008, but
the long-term question is what the portfolio manager in an
index ETF should be doing. Clearly, an important part of the
mandate for an index fund manager is to deliver a return representative
of the index. If the portfolio manager’s mandate
is asset allocation or market timing (in the sense of reducing
or increasing equity exposure to anticipate the direction of
the market), then a cash balance is certainly appropriate—at
times. In most index ETFs, however, holding cash balances all
the time is not part of the portfolio manager’s job description.
Figure 1 shows some suspiciously “lazy” returns in two
strong market years and two weak market years.
Figure 1 shows tracking error calculations for a group of
29 U.S. ETFs that have been in existence since at least the
beginning of 2002. These funds all have domestic U.S. stock
portfolios. While the S&P 500 annual performance indicated
at the top of the column for each year studied may not be
representative of the portfolio in each fund, it is a fair surmise
that 2002 and 2008 were down years for all of these
funds, and 2003 and 2006 were up years. As the column
totals and the average tracking error for each fund in these
years indicates, the tracking errors were smaller in the down
years. In 2008, the average ETF even had a small positive
tracking error. In the up years of 2003 and 2006, every one
of the ETFs had a negative tracking error, and the size of
the negative tracking error was usually greater than the size
of the negative tracking errors in the comparable funds for
2002 and 2008. The only reasonable interpretation of these
results is that, on balance, these funds carried significant
cash balances in all four years.
Leveraged Long And Leveraged Inverse Funds
These funds track their leveraged benchmarks pretty well
on a day-to-day basis, as they are designed to do. Tracking
is not close when the funds’ performances are measured
against a simple leveraged multiple of the target benchmark
for periods longer than one day. This issue is explored
in depth elsewhere, including in Joanne Hill and George
Foster’s article in the September/October 2009 issue of the
Journal of Indexes.
Apart from showing how intensively an index fund manager
is keeping your money at work, tracking error can be a
useful framework for measuring how an active portfolio manager
is doing. Breaking the total tracking error measure of
the return difference between an index and a fund into positive
and negative elements can be a useful way to evaluate
what is going on in an actively managed fund and how well
or poorly the fund’s investment process works. In that spirit,
I turn next to analysis of differences in performance between
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January/February 2010