We talk a lot about what good investment vehicles exchange traded products are. How their low costs and ability to trade intraday make them an attractive product for both retail and institutional investors alike. Their other characteristics, such as being able to access any market, also make them attractive tools for investors, but it would be remiss of us to not look further into this and really establish what impact 'accessing any market' has.
A lot is made out of cost – that is the Total Expense Ratio (TER) of the ETP, but there are also some other costs that might impact your returns such as tracking error and tracking difference. Yes, they are two different things and the impacts they have on your ETP are also different.
Tracking error is how effectively the ETP is tracking its benchmark (underlying index).
Tracking Difference is the actual difference between a product's return and that of its benchmark over a specific time period.
For example, the RBS Market Access MSCI Emerging and Frontier Africa ex South Africa ETF (M9SZ) hasn't had a brilliant two years. In fact, its tracking difference has been off by 14 percent (see chart below). But according to a spokesperson from RBS, there is definitely no issue with the (ETF) exchange traded fund.
Another ETF which underperformed last year was the db X-trackers CSI300 Health Care UCITS ETF, which underperformed last year by 3.88 percent, while the db X-trackers Frontier Market ETF underperformed its benchmark by 1.68 percent.
On speaking with one market participant, they said that emerging market ETPs have high tracking difference in general because you have to consider the fee of the product, plus the transaction costs to access that market. There are also swap adjustment fees that are levied as a result of the hedging cost.
But worst of all, the iPath VIX Short-Term Futures ETN (VXIS), which tracks the S&P 500 VIX Short-Term Futures Index Total Return, is also down 97 percent on last year – ouch! (See the graph below)
So, what is happening here?
Well, all these ETFs have something in common: they don't track blue-chip indexes. Tracking niche markets is a tricky business and this is why the ETFs that do track these markets are traditionally synthetic (swap-backed) – it can become very costly when you start buying all the securities from the index.