False Tracking Error = Bad ETF Decisions

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October 24, 2012
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Tracking error tells you everything you need to know about how well your ETF is run, right? Think again.

 

Here’s how I know the ETF Revolution has long since passed, and what we’re living in now is the new ETF normal: The questions from advisors are getting a lot smarter.

I used to get emails about how creation and redemption worked. Now I get questions about tracking error.

Unfortunately, most people think about tracking error all wrong.

Here’s a perfect example. Take two funds that have been in the headlines a lot these past few weeks, the Vanguard MSCI Emerging Markets ETF (NYSEArca: VWO) and the iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM).

Now imagine you’re a Sophisticated Investor. You know a few things: You know expense ratio matters. You know spreads matter. You know tracking error matters.

So you pop up your Bloomberg, and here’s what you see:

 

EEM

VWO

Expense Ratio

67 bps

22 bps

Average Spread

~2 bps

~2 bps

Tracking Error

.602%

4.433%

 

Even on trading, Vanguard wins on expenses. But Holy Meatballs Batman, what are those guys down in Pennsylvania doing!? A tracking error of 4.433 percent?

And at this point, many advisors will make a critical mistake, assuming that the Vanguard fund is horribly mismanaged. It’s not an unreasonable assumption, if in fact this was an accurate tracking error number. But it’s not.

Remember, academic tracking error is the annualized standard deviation of daily return differences. If the index is up 1 percent today, and VWO is up 0.95 percent, well, that’s -.05 percent to add to the series. Take that whole series, plug it into your stats package, get the standard deviation, annualize it, and there you go.

There are a few reasons this is all a terrible idea. First of all, imagine that VWO was actually missing its mark by 0.05 percent, day in and day out. Well, the standard deviation of those daily differences will be zero. It’s enormously consistent.

Of course, if the index stayed perfectly flat all year, you’d lose a cumulative 12 percent of your investment in that “perfect” index fund. And because expense ratios are assessed daily, no matter how big, it will never show up as “tracking error.”

Second, “annualizing” a daily number is almost a useless exercise. A 0.01 percent daily standard deviation would equal about 0.16 percent annualized. A 0.05 percent daily standard deviation would give you about 0.79 percent over a year.

Neither of those figures actually has any bearing on whether you’ll be ahead of or behind your expected index returns, and since almost all tracking error is mean-reverting, in both cases your expected return likely centers somewhere around the index’s return, minus expense ratio.

In short, these kinds of tracking error measurements have essentially no bearing on actual investor experience. What most investors care about is holding period returns. So that’s what we look at here at IndexUniverse. We pose a simple question: What’s the difference between the index’s return over the past year, and the ETF’s?

 

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