How Well Run Is Your ETF?

November 18, 2016

Speaking of optimization, the SPDR S&P Emerging Markets ETF (GMM) has a highly optimized portfolio, and it shows. Its range is very large in comparison with the other funds in the space, and its median is depressed relative to its expense ratio. Optimization almost always introduces wider tracking differences, which is fine if they’re consistently working in your favor. Unfortunately, here it doesn’t look like they are.

If holding costs are your main concern, eliminating SCHE and GMM for poor tracking makes sense. Eliminating EEM on cost alone makes sense too, narrowing the choice of a cheap-to-hold vanilla emerging market ETF down to two funds: IEMG and Vanguard Emerging Markets ETF (VWO). Given that VWO’s positive median tracking difference is far more believable than IEMG’s, and that their overall range is quite similar, I’d say that VWO is the clear winner from a holding cost perspective.

Of course, there’s a lot more to consider than just tracking difference—the two funds have radically different investments, with VWO including Chinese A-shares but ignoring South Korea entirely, while IEMG invests 15% of its portfolio in the country. These exposure differences will likely dwarf any tracking difference comparison.

Where Tracking Difference Fails

Sometimes, tracking difference explains more about the index business than portfolio management. Take a look at the U.S. Aerospace and Defense segment, and you’ll see that one fund, the PowerShares Aerospace & Defense Portfolio (PPA), has an unexpectedly positive tracking difference.


Ticker Fund Name Expense Ratio Median Tracking Difference Maximum Upside Tracking Difference Maximum Downside Tracking Difference Underlying Index Return Variant
PPA PowerShares Aerospace & Defense Portfolio 0.64% 0.96% 1.28% 0.73% Price Return
XAR SPDR S&P Aerospace & Defense ETF 0.35% -0.32% -0.25% -0.43% Gross
ITA iShares U.S. Aerospace & Defense ETF 0.44% -0.46% -0.36% -0.52% Gross


These three funds have similar holdings, with heavy stakes in firms like Boeing and Lockheed Martin. Securities lending opportunities are most likely quite similar and limited for all three providers, but PowerShares has not been actively lending stocks in PPA’s portfolio. By rights, PPA’s 12-month tracking difference should be pretty close to its 64 bp expense ratio. But PPA’s tracking difference appears to be positive, by 0.96%.

In fact, the positive tracking difference is an illusion. The index that FactSet uses to calculate PPA’s tracking difference, the SPADE Defense Index, does not reinvest any dividend payments. We have no idea why, as virtually every index in the world is calculated as a total return index by default. In this case, however, the index provider simply doesn’t, which introduces a huge sandbagging effect. To get a clear picture, we need to back at the dividend yield from the index return.


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