Everything That's Wrong With ETFs Right Now

October 09, 2008

A look at tracking problems, credit problems and how the industry will change.

In the midst of all of the market volatility, there have been some very pronounced problems in the exchange-traded funds business. In addition to highly publicized issues around the Lehman default on the Opta ETNs, the problems with the short financial Rydex, ProShares and Deutsche Bank funds and the stopped trading and near default of the AIG-backed ETFS ETCs, there's been a whole lot of trouble out there.

Less publicized, but possibly even more disturbing, are the completely unreported credit risks around ETFs lending out their underlying shares to make handsome revenue (and then the ETF shares themselves being lent out by brokers) ... and we all know there is no free money. Who's borrowing the shares? They're collateralized? With what? We need more transparency/assurance here, particularly in this environment. I want to know that "You own the underlying" really means "I own the underlying" with no credit risk thrown in, thank you very much.

It's been a good time to get a gauge of all the product structure issues ... a sort of trial by fire.

There have been rumblings about tracking error, so I thought I would take a look at that.

Let's just look at some of the big funds and funds we know have had problems in the past or are in the news now. I used all iShares because, well, their Web site ROCKS. (We'll certainly do a big revised tracking error study across all families soon.) The iShares site is so far beyond all the other ETF issuer sites that it's almost laughable now, I hate to say. Every distribution, holding, spreads and equivalent index return right there. Just a pleasure to work with. We need to get our site where theirs is for ALL ETFs globally. We are working on it. All they need to add on the iShares site is a line on share lending revenue (good luck) or (maybe?) HOW the lent shares are being collateralized in each fund (i.e., with what):

Anyway, here's my sampling of tracking. This is as of 9/30, so it's missing some of the recent fun, but should give you a fair idea of where iShares is at anyway:


iShares Tracking Error Year-To-Date



ETF Return

Index Return


Tracking Error



Dow Jones U.S. Total





$0.45 billion


S&P 500





$14.2 billion


Russell 2000





$11.5 billion


DJ Dividend





$4.2 billion







$27.7 billion


MSCI Emerging Markets





$16.2 billion


FTSE Xinhua





$4.9 billion


S&P GSCI Commodities





$0.62 billion


Lehman Aggregate





$9.4 billion


Lehman 1-3 Treasuries





$8.8 billion


JP Morgan EM Bonds





$0.10 billion


Lehman Credit





$0.09 billion

Source: Barclays Global Investors. Data as of 9/30/2008


If you were looking for problems, welcome to tracking error nirvana, where (almost) all the tracking error is positive. I don't know whether to be dancing with joy or very, very nervous. Mostly dancing for joy I'd say. That EEM fund is just a tough beast to control with the optimization, liquidity and market opening issues. I like the Vanguard structure for that one and in less liquid areas on tracking error. EEM was down BIG last year on tracking error and is UP big this year. DVY I know iShares has publicly said they for all intents and purposes actively manage to optimize dividends. You optimize enough though, and you're obviously playing with tracking error fire. And if it can be 200 basis points positive, it can be 200 basis points negative more or less.

On all the rest, I guess we can attribute it to share lending (50% of revenues from that go into the fund), managing cash flow and index changes and, uh, maybe that cash is beating the crap out of about everything else right now. So the more cash you have on hand, the more positive tracking error you'll have in many of the funds. Not that iShares is doing that, but it can certainly be a way to buff up returns when markets are moving the wrong way. It's why active often outperforms indexed in bear markets.

We've got plenty more to look at. It's blogging heaven right now.



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