Beginning this year, providers of index-tracking UCITS will be required by European regulation to disclose predictions of their funds’ tracking error and tracking difference. Providers will also have to explain any divergence between their predictions and the funds’ actual performance.
Morningstar’s research report, On the Right Track: Measuring Tracking Efficiency in ETFs, examines the factors that influence tracking error and tracking difference in exchange-traded funds (ETFs), and applies those metrics to a selection of 65 ETFs linked to eight popular equity indices.
The key findings of the Morningstar report are:
| In general, ETFs have done well in limiting tracking error. | |
| ETFs using synthetic replication typically produce lower tracking error than those using physical replication. However, there is less of a direct relationship between tracking difference and a fund’s replication method. | |
| TER is the most predictable and easily quantifiable factor affecting a fund’s performance relative to its benchmark. Nonetheless, it is not the only one and, in some cases, may not even be the most important. | |
| Securities lending income, cash drag, tax optimisation, rebalancing costs for physical ETFs and swap fees for synthetic ETFs can also impact a fund’s relative performance. | |
| Contrary to popular belief, the relationship between tracking error and tracking difference is not particularly strong. | |
| As an alternative metric to tracking difference, Morningstar’s Estimated Holding Cost seeks to offer a smoother and more reliable measure of an ETF’s performance relative to its benchmark after all holding expenses and revenues. | |
| Beyond all tracking metrics, product and index construction, counterparty risk, bid-ask spreads, brokerage commissions, and tax considerations are some of the additional factors that should be considered by investors when evaluating an ETF. |
Hortense Bioy, director of European passive fund research for Morningstar, said:
“Tracking error and tracking difference both play a part as complementary measures for assessing the replication quality of an ETF. As ETFs continue to gain in popularity, there is an increasing need for investors to be clear about these most commonly used metrics. In particular, there seems to be considerable confusion around tracking error, its meaning, key drivers, and calculation. Beyond the definition provided last year by ESMA in its final guidelines on ETFs and other UCITS, we believe that investors would benefit from a harmonised approach to calculating tracking error. Our report intends to open up this discussion.”
For a copy of the full research report, please click here.
Authors
Ben Johnson, Director, Global Passive Fund Research
Hortense Bioy, CFA, Director, European Passive Fund Research
Alastair Kellett, CFA, CAIA, International ETF Analyst
Lee Davidson, ETF Analyst