How Well Run Is Your ETF?

November 18, 2016

The first thing you see is the median tracking difference is very close to the expense ratio (± 0.01%), which is exactly what you would expect.

You might not have expected the differences in the range, which is the tracking difference span from the maximum upside to the maximum downside. The tracking range is a great measure of variability.

SPY’s tracking range is four times the width of IVV’s or VOO’s. That’s huge! But there are probably reasons. SPY is structured as a unit investment trust base, which means it can’t reinvest any cash that comes in from dividends. The fund is required by law to hang on to the cash until it pays it to investors. From a pure tracking perspective, SPY is clearly the worst choice of the three.

VOO seems to edge out IVV, despite its slightly higher expense ratio. This is an accident of history: IVV cut its expense ratio from 0.07% to 0.04% last month. All else equal, we should expect IVV’s tracking difference to approach -0.04%, and likely equal VOO’s, as time goes by. These are truly minuscule differences—too tiny to make or break an investment decision.

Tracking Difference And The EM Space
Tracking difference is useful in international funds, too, but you need to be a bit savvy about index construction to use it well. The next example of emerging market vanilla ETF tracking difference introduces a wrinkle; variability in the indexers’ practices around foreign dividends.

 

Ticker Underlying Index Provider Expense Ratio Median Tracking Difference Maximum Upside Deviation Maximum Downside Deviation Tracking Range Index Foreign Dividend Withholding Rules
IEMG MSCI 0.14% 0.08% 0.51% -0.04% 0.54% Institutional
EEM MSCI 0.69% -0.44% -0.33% -0.67% 0.35% Institutional
SCHE FTSE 0.13% -0.12% 0.27% -0.65% 0.92% Institutional
GMM S&P 0.59% -0.90% -0.29% -1.61% 1.32% Institutional
VWO FTSE  0.15% 0.07% 0.45% -0.11% 0.57% RIC

 

A Few Observations

The iShares Core MSCI Emerging Markets ETF’s (IEMG) and the iShares MSCI Emerging Markets ETF’s (EEM) apparent outperformance versus their expense ratio is likely attributable to inadvertent sandbagging; MSCI’s rules for accounting for net withholding are simply far more conservative than the actual experience of a U.S. fund running an ETF, and so the funds “pick up” that difference as positive relative performance.

The Schwab Emerging Markets Equity ETF (SCHE) has that same sandbagging relative to VWO, even though it seems like they track the same FTSE index series. The reality is they track slightly different index variants, with Vanguard’s registered investment company version a bit more realistic for a mutual fund in terms of withholdings than Schwab’s Institutional one.

Even so, SCHE’s tracking difference is still not great, underperforming by a median of 12 bps. That’s significant. Its overall tracking range of 0.92% is surprisingly large, in context. Why? Again—impossible to know precisely, but I’d suspect differences in securities lending revenues and optimization, as SCHE holds only 850 of the 982 stocks in the FTSE emerging index.

 

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