It’s great to find an ETF with a dirt-cheap expense ratio, but it’s even better to find a fund that tracks its index closely.
Since ETF investors can’t own indexes directly, the next best thing is to choose a fund that has the smallest tracking error.
Generally, expense ratios are good indicators—all else being equal, smaller management fees usually give investors more returns.
However, holding down costs, even in plain-vanilla ETFs, doesn’t necessarily translate into minimizing the difference between fund and index performance.
What can help explain the differences between management fees and tracking error are two things: first, portfolio turnover; and second, securities lending.
Let’s tackle portfolio turnover first. During rebalances, some funds are more efficient than others, whether that’s due to lower turnovers or better manager skill.
For example, the table below compares three funds that track the S&P MidCap 400 Index:
- iShares S&P 400 MidCap (NYSEArca: IJH)
- SPDR S&P MidCap 400 (NYSEArca: MDY)
- Vanguard S&P Mid-Cap 400 (NYSEArca: IVOO)
Despite the difference in holding costs, IJH and IVOO are nearly identical in tracking.
This can be partially explained by the turnover frequency. Both funds use a passive investment strategy on the same index, yet IVOO had nearly twice as much turnover as IJH. Frequent trades hike up transaction costs for maintaining the exposure to the index and contribute to tracking error.
Another factor to consider is securities lending. Some funds are able to claw back returns through lending securities in their portfolio. Additional profits are put back into the fund to pump up investor returns.
The securities-lending split—how much managers invest back into the fund—varies by ETF issuer. IVOO’s provider, Vanguard, allocates 100 percent of securities-lending profits back into the fund, whereas iShares rebates around 65 percent to shareholders.
Turning back to our example, it doesn’t require a big leap in logic to assume that IVOO’s tracking error would have been much larger had all securities-lending revenue not been reinvested into the fund.
Therefore, it could have been more efficient in trading holdings at rebalance. IVV didn’t reach its full potential either, since only 65 percent of profit from securities-lending made it back to the portfolio.
Sometimes, legal structure also comes into play. MDY competes with IVOO and IVV, but plays by different rules.