A Second Look: Tracking Error & Emerging Markets

April 06, 2009

Differing cost structures and methods of tracking indexes are critical when assessing ETFs. But such concerns are heightened in developing markets.

 

Editor's Note: This is an updated version of a column that appeared on IndexUniverse.com last week. It also has been corrected to better reflect return and correlation metrics presented in the report. In theory, the market price of an exchange-traded fund should closely track the value of its underlying holdings, typically referred to as the fund's "net asset value," or NAV. Likewise, those NAVs are expected to closely follow the performance of an ETF's underlying index.

 

The market is responsible for keeping the market price close to the NAV, and the fund company is responsible for keeping the NAV close to the index value.

In this way, in normal conditions, ETF prices just follow the leader from where security prices are set on the market in the underlying securities. This is why there are arbitrage mechanisms in place to encourage the market to value the ETF based on the value of the underlying holdings.

Such an arbitrage opportunity allows market makers that are Authorized Participants for the fund to redeem the basket of underlying stocks at NAV, profiting when the NAV shares are trading above the ETF price, and to create ETF shares at NAV when the ETF is trading above the NAV price.

Emerging Market Tracking Error

There's a lot of confusion on how to properly manage and discuss the tracking error in an ETF. In the common conception, tracking error simply refers to the difference between the return of a fund and the return of a benchmark index over time. If a fund went up 10% and its benchmark index rose 11%, the tracking error is said to be 1%.

In the academic literature, tracking error is expressed as the standard deviation of this difference. That's perhaps more accurate, as it places things in proportion: 1% of a 2% return is a much bigger deal than 1% of a 20% return. The aforementioned lay understanding of tracking error is technically called "excess return" ... but in practice, it's also referred to as tracking error. Regardless of what you call it, though, it shows how well the ETF issuer is doing at meeting its objective of replicating the index's performance.

Tracking error can be an implicit cost of investing in one ETF over another, especially when two ETFs track similar indexes. In some cases, this may be a more important cost than the explicit fees from the ETF's expense ratio.

Emerging market ETFs have many unique features that make them different from other ETFs, while still remaining an easy and cost-effective way for many investors to gain access to developing economies. Currently, there are two popular ETFs that cover the broad-based emerging market asset class, the iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM), and the Vanguard Emerging Markets Stock ETF (NYSEArca: VWO). Both the iShares and Vanguard product have an objective to track the MSCI Emerging Market Index.

Figure 1 shows the performance difference VWO and EEM have had on a monthly basis from the MSCI Emerging Market Index since the inception of VWO in March 2005. The figure uses the ETFs' NAVs, rather than share prices.

That's an important distinction, and there are arguments for using both share price and NAV when evaluating tracking results. The advantage of using NAV is that the share price can be influenced by short-term buying and selling trends, which can temporarily cause the ETF to trade at a premium or discount to its NAV. The disadvantage is that, for funds that track foreign markets, those markets may not be open during the same time that the ETF is trading, making NAV calculation a subject for debate.

For example, let's say that the markets in Asia close at a certain level. Later that day, economic news breaks that shows that the Hong Kong economy is slowing. An ETF tracking emerging markets, with significant holdings in Hong Kong, may trade down on the news. But the market in Hong Kong is closed, so the share prices of the underlying holdings in the fund don't change.

Companies can either adjust the NAV of the fund based on an evaluation of what the "fair market value" would be if the underlying holdings were trading, or they can simply let the fund price diverge from the NAV and stick with the static NAV price. Vanguard says that it consistently applies fair value adjustments to its ETF NAVs, while iShares' prospectus states that it applies fair value adjustments in certain situations. The market value of the ETF, in contrast, should in theory provide active price discovery into what the value of the underlying would have been had they been trading.

If you look at the monthly excess return of VWO and EEM versus the MSCI Emerging Markets index on a NAV basis, you'll see that VWO is more prone to having outlier tracking error compared to EEM. Is that because of the fair value pricing or because of fund tracking error? To understand, let's look at what causes tracking error.

 

Figure 1.

Tracking Error: M. Return Diff. From Index

 

 

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