As ETFs have looked beyond the low-hanging fruit of large-cap stocks and entered new markets, ETF issuers have been presented with new challenges.
Near the top of that list is tracking error—the difference between the index fund’s performance and the index it tries to track.
Tracking large, liquid stock indexes like the S&P 500 is relatively easy, and tracking error is essentially zero for those ETFs. When it comes to bond indexes containing thousands of securities, it’s a different ball of wax.
As ETFs have branched into new market segments with broader or more obscure indexes, tracking error has become a harder beast to tame.
The reason tracking error looms larger for more esoteric indexes is that it can be difficult for fund managers to hold all the securities contained in the index—either for liquidity or scarcity reasons.
That’s particularly true in the world of fixed income, where massive indexes containing thousands of securities—some of them obscure—are more common. Moreover, bonds trade over the counter, so they lack the immediate liquidity of stocks.
What that means for investors is that they can’t always assume an ETF will give them exactly what it promises; namely the returns of the index minus expenses.
I pulled up the tracking error of a series of high-yield bond ETFs, a sector that’s gotten particularly hot as yields elsewhere in the market remain low.
Once I accounted for expense ratios, several high-yield bond indexes had tracking error of 1 percent or more on an annual basis.
That means the portfolio you’ve decided to invest in will tend to diverge by more than 1 percent from its particular index. To put this number in context, it dwarfs the expense ratio of these funds, not to mention the tracking error of large-cap equity ETFs.
As a caveat though, annual tracking error can be hard to measure for funds that don’t have long histories.
The figures here come from annualizing daily differences between the fund and its benchmark. If those differences are mean-reverting, the fund’s actual returns will align closer to its index than the annualized number suggests.
I wouldn’t consider any of these tracking error numbers to be deal-breakers for those looking to invest in bond ETFs, but they are a reminder that market segments outside of the mainstream face challenges that shouldn’t be ignored.
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