Shopping Across ETF Legal Structures

May 21, 2018

[Editor’s Note: The following originally appeared on Elisabeth Kashner is director of ETF research and analytics for FactSet.]

In the ETF world, most investors pay scant attention to legal matters unless there’s a default or lawsuit. That’s a mistake. Understanding an ETF’s legal structure could lead to significant cost savings over time.

Investors focus on investment fees, and rightly so. Every penny paid in fund expenses is a penny that can’t grow for future use. While many investors look at fund management fees, ETF and index mutual fund investors have a more accurate way to gauge costs. Cumulative tracking difference shows the gap between the fund’s objective of providing the returns of a particular index and the actual returns.

Tracking difference comes in handy for anyone looking to understand the long-term costs of holding an ETF. If your target index returned 15.40% last year, while the ETF tracking it returned only 15.25%, you have a pretty good indicator that, no matter the stated expense ratio, your actual holding costs should come to around 0.15% per year.

Correctly Measuring Tracking Difference

When calculating tracking difference, the key is to match the treatment of cash flows for the fund and the index. If one is accounted for differently than the other, tracking difference will be misstated.

ETF returns are best measured by the fund’s net asset value (NAV). Unlike the ETF’s market price, which is quoted at the time of the last ETF trade, NAV is calculated based on portfolio holdings’ closing prices. NAV is a true reflection of the portfolio’s value, free from trading gaps, premia, or discounts.

An ETF’s total return NAV includes the reinvestment and compounding of dividends over time. Total-return NAV is an accurate reflection of the investor experience, in that it reflects both market appreciation and portfolio yield. Total-return NAV can differ dramatically from regular—or price-return—NAV, especially when yield is a major component of the overall return. The chart below shows the returns difference since inception for the iShares Core U.S. Aggregate Bond ETF (AGG).



(For a larger view, click on the image above)


The difference is dramatic. In the 15 years since AGG launched, it has returned 3.75% per year, annualized through May 8, 2018. Yet the price return calculation would suggest a mere 0.32% annualized return. The total return version shows not just the magic of compound interest, but the most basic of bond fund features: coupon payments. All returns comparisons, including tracking difference, require total-return NAVs.

When measuring the performance of an ETF, total-return NAV must be matched with total-return index data. Calculating tracking difference including yield for the fund but excluding it for the index (using a price or excess return rather than a total-return variant) is hardly an apples-to-apples comparison. This is a misleading practice called sandbagging.

Fund Structure Impacts Operating Costs

Tracking difference comes in handy when analyzing complicated asset classes with multiple legal structures on offer. This is especially true in commodities, where there are four possibilities: grantor trusts, exchange-traded notes, commodity pools, and actively managed open-ended funds. Different legal structures could have different total costs because of their portfolio management requirements. Tracking difference, calculated on a uniform basis, allows investors to select the most efficient legal structure.

Commodity grantor trusts offer shares backed by precious metals. Grantor trust expenses include vault leases and security personnel, but not brokerage fees. There’s no portfolio manager, because the trust assets are not variable; there’s never a rebalance. It’s pretty much bars in, bars out, with a few sold every month to pay for upkeep. Commodity grantor trusts do not make distributions, nor do the trust assets generate income. There is no difference between regular and total return NAVs for commodity grantor trusts.

Exchange-traded notes (ETNs) also have no portfolio manager. Similar to structured products, ETNs are nothing more than a contract between an investor and a bank, where the bank promises to deliver a payout based on an index level. Nearly all commodity ETNs—including those from BarclaysCredit Suisse and UBS—specify that they track a total return index. ETNs represent unsecured debt obligations of the issuer rather than shares in a portfolio. ETN issuers are obliged to deliver a pattern of returns, but it’s the business of their risk desks to hedge that obligation. Because they mostly track total return indexes, ETN NAVs are generally stated on a total return basis, although a handful actually distribute income.


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