Raising Cash, Raising Tracking Error
Mutual fund portfolio managers don’t necessarily have to raise cash to meet dividend payments. If their in-house records indicate that most of their distributions are slated for reinvestment, they can treat the distributions as an accounting issue—distributions “buy” new shares on the ex-date, no cash changes hands.
ETF portfolio managers don’t have that luxury. Because ETF issuers do not have to keep shareholder records, ETF portfolio managers have no idea what share of distributions will come back to the fund. Therefore, ETF portfolio managers have to make sure they have sufficient cash to distribute. This means they might have to sell some securities, possibly incurring tracking error, and definitely paying trading costs.
And that’s just what we see. Take a look at the table below, which shows the mean daily standard deviation for all nongeared equity ETFS, sorted by trailing 12-month yields. As yields rise, tracking error rises too.
|Yield||Average Tracking Error|
|0.00% to 0.99%||0.06%|
|1.00% to 1.99%||0.05%|
|2.00% to 3.99%||0.07%|
|4.00% to 4.99%||0.09%|
|5.00% to 5.99%||0.08%|
|6.00% to 6.99%||0.10%|
|7.00% and above||0.14%|
Data: ETF.com as of 10/15/2014
A Better Mousetrap
Mutual funds are really, truly better than ETFs for dividend reinvestment. Mutual funds’ ability to pay distributions in stock, rather than cash, creates a seamless investor experience that ETFs can’t mimic. Delays, spreads, premiums/discounts and tracking error get in the way.
But let’s be clear: ETFs are still a better mousetrap. ETFs offer greater variety of exposures, lower expense ratios, better index tracking, cheaper tax bills, daily transparency and better portfolio management than their mutual fund counterparts. The DRIP drag costs don’t change the equation, even for extreme cases like IST.
DRIP drag really matters in two instances: It increases the efficiency of nondividend-paying ETNs over their ETF counterparts; and it makes Vanguard’s mutual funds a better access vehicle than its portfolio-sharing ETFs.
At the time this article was written, the author owned no positions in the securities mentioned. Contact Elisabeth Kashner, CFA, at [email protected].