Morgan Stanley: ETF Tracking Error Dropping

March 09, 2012

ETF investors are reaping the benefits of an industry that is cutting down fund tracking error.


ETF providers last year got better at what they do, serving up funds that more closely tracked the performance of their underlying indexes, according to a Morgan Stanley study that found tracking error across the U.S. ETF market has improved by 30 percent in the last year alone.

The Wall Street bank said that year-on-year, nearly three-quarters of U.S.-listed ETFs had lower tracking errors in 2011 than the year before, and only one in 11 funds had tracking error of more than 1 percent. Tracking error is the difference in total return between an ETF’s net asset value (NAV) and its underlying index.

Tracking error across the 700-plus U.S. ETFs surveyed in 2011 averaged 52 basis points at the end of 2011—as much as 22 basis points below the 2010 average, and a far cry from the 1.25 percent average seen just two years ago. What’s more, more than a third of the ETFs surveyed kept tracking error below the 25-basis-point mark, an improvement from a 1-in-4 ratio seen in 2010.

Tracking error is a key measure of just how good an index ETF is at meeting its goal of replicating its benchmark’s performance. It’s become increasingly important as ETFs canvass areas of the market broad and narrow, providing a viable alternative to more expensive active management. The Morgan Stanley study excluded active ETFs, as well as leveraged and inverse funds.

“As a result of lower tracking error in 2011, 53 percent of ETFs exhibited tracking error less than or equal to their expense ratios,” the company said in the report. “This is a constructive development for ETFs.”

Morgan Stanley noted that factors like fees and expenses of a fund, optimization and diversification requirements, scale, access to capital markets around the world, as well as index turnover and dividend reinvestment policies can affect a fund’s NAV relative to its benchmark.

“A higher ratio of expenses to tracking error corresponds to more effective tracking of index performance,” the company added.

Expense Ratios Are Key

Investors may not realize it, but what they pay in management fees is counted as part of tracking error and, moreover, it’s often the single biggest source of tracking error.

It shouldn’t come as any surprise, then, that U.S.-equities-linked ETFs tapping into style and major markets consistently show some of the lowest tracking errors because those ETFs also have some of the cheapest price tags.

Most U.S.-equities-linked ETFs—from major market funds, to style funds, to specific sector strategies—ended the year on average with tracking errors of 35, 26 and 47 basis points, respectively.

AMLP: A Case Unto Itself

By comparison, U.S. equities ETFs with niche strategies that invest in everything from a buy-write portfolio to clean energy as well as long/short funds—had average tracking error of as much as 95 basis points, and were the only category of U.S. equities ETFs that saw tracking error performance deteriorate in the last year.

Behind that performance shortfall was the biggest offender in the tracking error game: the Alerian MLP ETF (NYSEArca: AMLP), an ETF that serves up a portfolio comprising master limited partnerships that also happens to represent more than 40 percent of total assets in the “U.S. Custom ETFs” space surveyed, the report said.


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