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Understanding Tracking Error

Understanding Tracking Error
March 28
23:47 2012

In a recent discussion of exchange-traded notes (ETNs), we mentioned the absence of tracking error as one advantage that ETNs have over exchange-traded funds (ETFs). However, ETFs can be a valuable component of any trading strategy, so it is important to understand what tracking error is and why it results. You can then evaluate the tracking error associated with any ETF you are considering and determine its impact on your trading strategy. Forewarned is, as the saying tells us, forearmed.

First, understand that an ETF is designed to mimic the performance of some underlying benchmark. In the case of the SPDR, for example, that benchmark is the S&P 500 Index. Given that as of February 2012 there were almost 1,200 ETFs available in the U.S., the variety of benchmarks being tracked is mind-boggling. An ETF can represent an index, a set of indices (think of regional international equity ETFs that track, for example, all markets in Latin America or Asia), an industry, a commodity or family of commodities, and so forth.

ETFs are almost without exception passively managed—that’s why they follow a benchmark. Nevertheless, ETF managers face the challenge of tracking their particular benchmark as closely as possible while minimizing costs. Much of what they do is automated, particularly when it comes to dealing with equity indices. Extensive automation becomes a necessity when you consider how often the makeup of many ETFs changes.

For example, returning to the example of the SPDR, the S&P 500 is a market capitalization-weighted index. That means as each component stock’s market cap fluctuates against the total market cap of the index, its share of the index changes. This need for constant trading introduces two factors that produce tracking error: the fact that all the necessary trades cannot be made simultaneously and instantly, and the fact that the buying and selling activity will in many cases influence the stock price, albeit slightly. In addition, trading costs money, so the more trades an ETF makes, the more costs it incurs.

Another cause of tracking error is rather obvious: fund expenses. Fund managers have to be paid, most ETFs have marketing costs, and of course the funds are in business to make a profit. The deduction of these expenses is normally the single largest source of tracking error.

For some highly specialized ETFs, U.S. securities regulations regarding diversification come into play. The SEC dictates that an ETF may hold no more than 25% of its portfolio in any single stock, but in the case of certain industries that are small or contain a highly dominant company, accurately replicating the sector might require exceeding that 25% limit. Since that is not a legal option, a tracking error—and potential a substantial one—is inevitable.

It is also possible to introduce positive tracking error—that is, factors that drive the ETF returns above the benchmark’s returns. The major one is securities lending. This results mostly from short-selling stocks, since the seller has to borrow the stock to be sold. The lender in these cases tends to be an institutional investor, which is what ETFs are. Since borrowers of stock pay interest just as borrowers of cash do, these interest payments represent additional income for the ETF. Of course, the small positive tracking error that is introduced normally serves only to reduce the negative tracking error produced by the other factors we have discussed.

Two key metrics to consider in evaluating tracking error (and how well an ETF matches its benchmark overall) are R-squared and beta. R-squared is a measure of how closely the ETF tracks the benchmark, and it should be very close to 1. (Some measures use 100 instead.) An R-squared of 0.8 or 0.7 (or 80 or 70), or even lower, indicates extremely poor tracking.

Beta, which is a measure of volatility and therefore risk, should be very similar for both the ETF and its benchmark. The actual measure of beta is not the issue (so long as you understand the degree of risk it represents), only that the ETF matches its benchmark.

These guidelines will give you a basis for evaluating ETFs as you plan your trading. Remember that tracking error is typically only a few tenths of a percent for ETFs, and that it increases the longer you hold the fund, so it is usually not a major issue in short-term trading.

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