The Trouble With ETFs: Part II

Posted by: Lauren Young on January 29, 2008

The whole point of an exchange-traded fund is to mirror the returns of the index it tracks. Well, Morgan Stanley has just updated its data on ETFs and how well they match their benchmarks. Some ETFs are missing the mark by a wide margin.

In industry-speak, this problem is called “tracking error”, which is defined as the difference between an ETF’s return and that of the index it’s supposed to replicate. Tracking error is even more illuminating when you factor expenses into the equation.

While tracking error for most major market segments was generally in line with levels observed in 2006, Morgan Stanley found “a broader range and magnitude of tracking error in 2007. While average deviations remained modest, we observed more cases of high tracking error. The high level of new issuance over the past few years has broadened the range and complexity of ETFs. Many recently listed ETFs are based on newer or less well-known benchmarks that may be harder to track,” according to the report.

There are many reason why tracking error ocurs, so look at last year’s list of ETFs with big tracking errors to get a better understanding of how it happens.

Here are the six ETFs with 2007 tracking error greater than 300 basis points, excluding expenses:

Fund Name/Tracking Error
Vanguard Telecom Services (VOX): 478 basis points
iShares MSCI Emerging Markets (EEM): 408 basis points
PowerShares FTSE RAFI Utilities (PRFU): 338 basis points
PowerShares Water Resource (PHO): 285 basis points
PowerShares FTSE RAFI Consumer Goods (PRFG): 278 basis points
PowerShares Financial Preferred Portfolio (PGF): 273 basis points

Source: Morgan Stanley Research, ETF Providers and Trustees, Bloomberg, Thompson

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Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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