5 ETFs Crushing Their Indexes

Some ETFs really do track their indexes better than others.

Investors often spend much of their time focusing on an ETF’s expense ratio without taking into consideration the fund’s total holding costs.

For example, if an ETF charges only 0.20 percent a year, but it trails its underlying index by 100 basis points over a 12-month period, the ETF’s true holding cost over that period is actually 1 percent.

On the flip side, every so often, we have ETFs that outperform their underlying indexes due to sound portfolio management and a savvy securities-lending program. But more on that later.

In a simplified world, an ETF should trail its underlying index by roughly its expense ratio. But we all know that in the real world, other factors play a major role in tracking, such as optimization, trading costs, taxes and other expenses.

Many ETFs optimize their portfolios, or take a sampling approach, rather than replicating them exactly with the index. For international ETFs, managers can even hold American depositary receipts instead of the ordinary shares that are held in the indexes. These factors can cause slippage from the index on either the upside or downside.

Most investors prefer their ETF to track its index closely with consistency and minimal variability over time, but I also know of analysts who would argue that ETFs shouldn’t beat their indexes, and frown upon outperformance.

As an ETF investor myself, I don’t have any issue with an ETF that outperforms its index, as long as it’s done consistently and with minimal downside deviations. To me, these ETFs not only offer “free” holding costs to the investor, but provide additional gains, which I certainly won’t complain about.

Measuring Tracking

We take ETF tracking seriously here at ETF.com Analytics. There are several ways to measure it, but we display “tracking” on our reports based on rolling 12-month tracking differences over a two-year stretch.

We display three measures: the median 12-month tracking difference; the max upside 12-month deviation; and the max downside 12-month deviation.

We display the max upside and downside deviations because we think consistency and variability is also of critical importance.

For example, if an ETF has a median tracking difference of only 0.10 percent over rolling 12-month periods, but it trailed the index by 1.50 percent over one specific 12-month period, that poses some serious problems for an investor who was unlucky to invest in the fund during that poor stretch.

The Standouts

I’ve scoured our ETF landscape for the top five standouts that exhibited not only strong median 12-month rolling differences, but also showed little to no downside slippage over two years.

There are several ways a fund can have positive tracking, but as I stated earlier, one of the most common ways is through securities lending.

Securities-lending revenue is classified as income and can be used to offset the fund’s expenses. Before the income is distributed, it can also be reinvested back into the fund, which can produce positive tracking (remember the underlying index doesn’t take into account any income from securities lending).

Not surprisingly, we have two ETFs in the list from the renewable energy sector, and one "rare earths"-themed ETF. The underlying stocks in these types of portfolios are often harder to borrow for those looking to short the stocks, and ETFs are able to charge more for lending out these securities.

We also have an international midcap ETF on the list that doesn’t have a screaming securities-lending explanation for its outperformance. This might simply be due to an optimized portfolio or savvy management that’s worked in the fund’s favor over the past two years.

Keep in mind as you look at this list that positive tracking is not in itself a reason to invest in an ETF, nor does it make these ETFs in the list great investments. This list is merely a shout-out to those ETFs that have managed to not only claw back all their expenses, but outperform their indexes on a consistent basis.

(Note: List order by median tracking difference. Funds with a negative downside deviation greater than 100 basis points were excluded. I also want to stress that this data is specific to the past two years, and only ETFs with two years of trading history were considered. ETFs that changed their underlying indexes within the past 24 months were also excluded).

5. iShares Global Clean Energy (ICLN | C-22)

4. Market Vectors Rare Earth/Strategic Metals (REMX | F-3)

3. SPDR S&P International Mid Cap (MDD | D-81)

2. Market Vectors Russia (RSX | C-64)

1. Guggenheim Solar (TAN | B-39)

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.