To compare and select exchange-traded funds (ETFs) managed against the same index, investors can use a range of criteria including the cost of the fund or the extent to which its investment portfolio deviates from the list of index components.
Among the most commonly used are
Other criteria may be taken into consideration such as
These, however, do not reflect the fundamental characteristics of the ETF.
Recently, more and more investors have been analysing ETFs on the basis of tracking difference, or the ‘performance gap’, a measure which is highly complementary to tracking error.
Tracking difference can be explained by several factors:
Several factors can generate negative tracking differences (TD). The first among these are management fees or other fees to which the ETF is subject. If they are significant, structural underperformance may result. Typically, fees vary depending on the asset class and region being replicated.
Fees for buying and selling securities to maintain target asset allocations are a cost to the fund. They are either one-off in nature (upon each rebalancing of the index in the case of physical replication) or, in the case of a swap and synthetic replication, spread out over several months as they are included in the price of the swap.
Execution costs may arise when investing subscriptions or raising cash to meet redemptions. This would involve the buying or selling of assets where an ETF is managed using physical replication or an adjustment of the size of a swap to maintain 100% exposure in the case of synthetic replication. However, this cost is systematically offset by subscription or redemption fees paid by the market maker authorised to create or redeem shares in the ETF.
There are ways to enhance the tracking difference. For example, tax incurred on actual dividends compared to the tax applied to an index by an index provider (who calculates the index returns using pre-determined rules) can provide a source of additional returns to the fund.
Other sources of additional income may be securities lending or optimisation of security management. In the case of synthetic replication, judicious management may result in advantageous financing terms from counterparty banks, along with their special access to the market.
Ultimately, this can result in additional returns for the end-investor. The use of open architecture by counterparties for swaps can also generate competitive prices for swaps and may improve a fund’s tracking difference even more.
In any case, the period of measurement must be sufficiently long, that’s to say at least a year or more, to be considered representative.
Over a short period, tracking difference can be skewed by, for example, the seasonality of dividends. It should be noted that tracking difference is easily calculated: just compile an ETF’s performance data over the desired time period (using the ETF’s NAV and not transaction prices) and those of the index being replicated (based on the index’s benchmark level as stated in the prospectus).
Any bias that could lead to a miscalculation and, hence, an incorrect measure must be eliminated. To compare ETFs, it is essential to calculate tracking differences on the basis of the same index of replication to retain the same basis for calculation.
For example, the tracking difference of an ETF relative to a net total return index (i.e., with reinvested dividends and on an after-tax basis) cannot be compared with the tracking difference of an ETF managed against a price return or gross total return index (i.e., with reinvested dividends and on a pre-tax basis).
As with any calculation methodology, special attention must be paid to the periods under consideration, the price sources used (NAV versus last market price) and the exchange rate if the indices or ETFs are denominated in different currencies.
When properly calculated, the tracking difference is an easy-to-use and direct measure and essential when comparing ETFs. In terms of total portfolio return, tracking difference is in our view a measure of the quality of the management of a tracker.
In active management, an investor selects a fund by analysing, among other things, its performance track record. In index management, we believe any comparison of performance track records must include an in-depth analysis of the tracking difference.
As managers seek to maximise the Sharpe ratio, optimising tracking difference, tracking error and the information ratio must be their primary goal.
Investments in the aforementioned fund are subject to market fluctuation and risks inherent in investing in securities. The value of investments and the revenue they generate can increase or decrease and it is possible that investors will not recover their initial investment. Source: BNP Paribas Asset Management Holding.