GSG Tracking: What Really Happened?

July 27, 2011

The Source Of Recent Tracking Error
One obvious question is whether the use of CERFs—as opposed to traditional (and more liquid) futures contracts—has increased the likelihood of negative tracking error for GSG.

A look at the annual returns for GSG suggests otherwise. In 2009, for instance, GSG actually outperformed its benchmark by 1.64 percent. That move came after two years of underperformance, which may indicate that the fund’s tracking error is mean-reverting.

The long-term track record backs that up. Since inception in 2006, GSG has returned -27.54 percent, just 3.97 percent below the benchmark return. That is very close to the 3.70 underperformance that would be expected based solely on the 0.75 percent annual expense ratio compounded over five years.

While it’s impossible to say exactly what caused GSG’s recent underperformance, there are two leading theories—both of which, curiously, actually augur well for the fund.

The first is that 2011 was the first-ever roll by GSG. With the starting round of contracts expiring, iShares had to roll the entire portfolio into new contracts. This could theoretically have led to slippage.

There’s no exact way to test this, however, and the previous variability of tracking performance says that this is unlikely to be the true driver of the returns difference. If it were, investors would not have to worry about it again until the spring of 2014, when the next wave of CERFs expire.

The second and more likely explanation is futures mispricing, whereby GSG’s underlying holdings—the CME CERFs—trade away from their intrinsic value. Futures contracts are designed to converge with spot returns by expiration; prior to expiration, they may temporarily trade away from “fair value.” Under this scenario, the vacillating tracking performance would be driven by movements above and below fair value for the underlying contracts.

This would cause the tracking error to be roughly mean-reverting—after all, the CERFs must revert to fair value by their expiration in March 2014. If they underperformed this year, then one might expect them to reverse course in ensuing years. That roughly aligns with the variable annual tracking performance we’ve seen since GSG’s launch in 2006, and would suggest that periods of underperformance will eventually be matched by periods of outperformance.

In short, we can expect to see the different tracking experiences continue. While this year’s 2.18 percent underperformance is concerning, history suggests that much of that may be reversed in the future. This is especially true in light of GSG’s extremely solid tracking performance since the trust’s inception.

Rival GSP—the ETN—has had more consistent performance, staying tighter with the underlying index. Over the long haul, it has generated slightly superior performance for investors, with a 3 percent underperformance over the same period compared to GSG’s 3.97 percent.

For many investors, the tighter tracking performance of GSP must be weighed against its greater credit risk and inferior liquidity, with the latter point being perhaps the most important consideration.

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