Sec-Lending Disinformation

February 22, 2013

Tracking-error study regarding securities lending by ETF firms confuses the issue.


The old adage that everything you read on the Internet must be true took a major hit today, as a flawed tracking error study comparing ETFs that lend securities to those that do not made its rounds.

In the past two years, IndexUniverse has gone to great lengths to ensure the data we use to analyze ETFs is both clean and trustworthy. While that may seem like a simple endeavor, in reality it has been a painstaking process that has cost us hundreds of staff hours.

At the heart of our mission, however, was being able to effectively and accurately measure ETF tracking error. In doing so, we found it can be easy to misinterpret tracking differences. One common mistake, which showed up in the blog post from the Securities Litigation & Consulting Group, was that comparing total return NAV to a price return index would produce misleading results.

Now, this is not an indictment of SLCG, per se. After all, some issuers don't publish total return versions of their indexes. That said, the majority of index providers do provide total return index levels, so any study analyzing tracking error that does not compare total return NAV to the total return version of the underlying index will produce erroneous results.

Furthermore, there are some issuers who fair-value their NAVs for ETFs holding international securities, which will cause the published total return NAVs to deviate (sometimes greatly) from the index. The cause of this is simple to understand: An index simply reflects the prices (adjusted for distributions in the case of total return indexes) of the securities it tracks, and when foreign markets like, say, Hong Kong or Hanoi close, the index will not update during the portion of U.S. market hours that those markets are closed.

Fair-valued NAVs, on the other hand, use a model to estimate the price of the portfolio using things like futures, ADRs and highly correlated securities. The reason issuers do this is to try and dampen intraday premiums and discounts in the ETF market. This disconnect will cause tracking differences to appear larger than they (likely) actually are.

There is also another little-known quirk in indexing and NAV calculation that can be easily overlooked that pertains to international ETFs. There are some index providers that strike their currencies at the local market close, while the issuer of funds tracking those indexes strike their currencies during U.S. market hours. This creates another potential wedge between NAV and the index level that cannot be fully captured in a simple tracking error calculation.

As such, any robust study of tracking error will need to take all of these things into consideration in order to ensure you're comparing apples to apples.



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