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for this kind of analysis. Investors increasingly pay advisers for
advice in fund selection. Advisers who can prepare themselves
to undertake this kind of analysis over the next few years will
provide much better service to investors they have “trained” to
appreciate the analytical nuances that will soon be routine.
All index ETFs should be evaluated relative to benchmarks
other than their template index. Whether an index fund is
based on (1) a popular benchmark, (2) a custom backtested
index touted to outperform a specific market segment, or (3)
an index constructed to have less costly composition changes
or to lack trading transparency, the fund’s performance
should be evaluated by calculating its tracking error relative
to one or more appropriate independent benchmarks. ETFs
using indexes that were created from a backtest can only be
meaningfully evaluated relative to an independent benchmark.
In the long run, the most appropriate single measure
of the value any fund delivers to its shareholders is its tracking
error relative to an independent benchmark that represents
a comprehensive, RIC-compliant, float-weighted basket of the
securities in the universe eligible for inclusion in the fund
portfolio. The result of such a calculation may be very different
from what we get from a tracking error calculation relative
to an index fund’s template index, particularly if tracking
errors are calculated and evaluated over a period of years.
The ideal benchmark would be an index that meets the investability
requirements for a benchmark, yet does not serve as a
template for any portfolios. The performance of an index that
serves as a portfolio template will be adversely affected by the
costs of implementing index composition trades.
Let’s start to break tracking error down into a few of its
components to illustrate some of the possibilities. The breakdown
that follows is certainly not the only way to decompose
these elements, but it is a useful illustration. Some possible
values for breakdown components are illustrated in Figure 2,
but keep in mind that these values are for purposes of illustration.
They do not represent an actual fund.
Negative (Cost) Elements Of Net Tracking Error
Fund Expense Ratio
Of course the easiest fund cost element to find is the
fund’s operating expense ratio. The expense ratio—and
Figure 2
often a breakdown of its components—is readily available
for all funds. In some cases, there is a cap on expenses or a
unitary fee that determines the expense ratio independent
of actual costs. Expenses are a negative component of the
net tracking error calculation. The ready availability of the
expense ratio and publicity given relatively low expense
ratios by index mutual fund and ETF sponsors has made it
the second-most-popular measure used for fund evaluation. 5
’Obscured’ Expenses Charged To Transactions
Or To Securities Lending Revenue
Apart from brokerage commissions on portfolio trades
that are universally excluded from the fund’s expense ratio,
two other cash expense items are not ordinarily included in
the fund’s expense ratio. The most common of these excluded
expenses are transaction-linked ticket charges and line item
charges collected by the fund’s custodian. These charges are
usually small and will be reflected in one way or another in
the cost or proceeds of transactions made for the portfolio.
These charges are an “obscured,” if not hidden, expense.
A second expense element that is usually not part of the
expense ratio is the portion of any securities lending fee
that is retained by the fund’s securities lending agent. The
portion of securities lending fees retained by the securities
lending agent has a negative impact on any tracking error or
performance calculation. The gross securities lending fees
received are a positive element.
Trading Costs
Trading costs of a fund are not published as an identifiable
cost item, but they can be calculated with reasonable
accuracy from data that is reported on a fund’s trades. The
most easily determined element of trading costs is cash commissions
paid by the fund to brokers that execute the fund’s
transactions. Commissions are reported to the Securities and
Exchange Commission for a fund or for all funds in a series.
While careful analysis 6 may be necessary to obtain a figure
for the commission payment per share traded (the most
common measure used), such calculations are well within the
capabilities of fund services today. Fund commission rates
that average more than 4 cents per share will be unusual
Illustrative Breakdown Of A Mutual Fund’s Net Tracking Error Relative To An Appropriate Benchmark Index
Negative (Cost) Elements
Expense Ratio -1.21%
Expenses Charged to Transactions
or Securities Lending
nm
Trading Costs
Flow -1.08%
Discretionary -0.36%
Withholding Taxes
nm
Total Costs -2.65%
Net Tracking Error -1.88%
Positive (Value-Added) Elements
Market Timing -0.02%
Miscellaneous Fund Income
nm
Apparent Value Added
by Fund Management Decisions +0.79%
Total Value Added +0.77%
www.journalofindexes.com January/February 2010
53