Does Your ETF Provider Reveal Tracking Error?

When choosing a passive fund, it is important to consider fees, replication method, whether the fund is accumulating or distributing and the tracking metrics

Kenneth Lamont 19 December, 2014 | 4:51PM
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When considering an investment in an ETF, the sheer breadth of options available can be bewildering. Some of the key points of comparison that investors typically use when choosing between funds include index composition, fees, replication method and whether the fund is accumulating or distributing.

But when it comes to tracking quality, investors should focus on two key metrics: tracking difference and tracking error. These metrics are often used interchangeably but in fact they measure two very different things.

Tracking difference is defined as the difference in returns between a fund and its underlying index. Tracking difference is usually negative, meaning that the ETF underperforms its benchmark. Assuming otherwise perfect tracking, an ETF should underperform its benchmark by an amount equal to its total expense ratio on an annual basis. This metric is useful because it represents the total annual cost of holding the fund (note: it doesn’t include investor specific factors such as the cost of trading the ETF or tax considerations).

Tracking error is the volatility (as measured by the standard deviation) of a fund’s return differences versus its benchmark. A low tracking error indicates the fund has consistently tracked its benchmark.

For more details on these metrics, see our recent article On the Right Track: Measuring Tracking Efficiency in ETFs.

Since 2013, tracking difference and tracking error have been required by the European Securities and Markets Authorities (ESMA) to be disclosed in annual reports. Fully cognisant of the importance of these two metrics in investors’ decision making process, a number of providers have taken the initiative to display the metrics prominently in their marketing literature, including ETF webpages and factsheets.

Others, however, have not considered it necessary to do so. Some of these providers may argue that the data required for the calculation of both metrics is available on their websites. But, particularly in the case of tracking error, this can be a time consuming process for investors and forms another step that must be taken before a clear comparison between ETFs can be made.

To illustrate, I have provided a current snapshot of those, among the top European ETF providers, who do and who don’t prominently disclose tracking difference and tracking error in their marketing literature.

While it should be re-stated that for all the above providers, both the required metrics can be accessed in the appropriate annual reports or be self-calculated, it is in the interest of the investor to have them readily available on the website and/or factsheets.

As we can see from the table, HSBC, Lyxor, Source and SPDR all provide both metrics to individual investors in this way. Conversely, iShares and ETF Securities are the only major providers to offer neither outside of their annual reports.

Steps taken by providers to clearly present information surrounding holding costs and tracking ability prominently on their websites and factsheets should be applauded. For example, db X-trackers now includes a full breakdown of estimated annual holding costs on their website, including management fees, fixed-fees, securities lending returns, and swap enhancements/costs – which can be positive or negative.

While, clearly progress has been made, there remains a distance to travel before investors can quickly and efficiently compare ETF offerings across providers.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Kenneth Lamont  is a passive funds research analyst for Morningstar Europe.