Courtesy of Dave Nadig

Here’s how I know the ETF Revolution has long since passed, and what we’re living in now is the new ETF normal: The questions from advisors are getting a lot smarter.

I used to get emails about how creation and redemption worked. Now I get questions about tracking error.

Unfortunately, most people think about tracking error all wrong.

Here’s a perfect example. Take two funds that have been in the headlines a lot these past few weeks, the Vanguard MSCI Emerging Markets ETF (NYSEArca: VWO) and the iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM).

Now imagine you’re a Sophisticated Investor. You know a few things: You know expense ratio matters. You know spreads matter. You know tracking error matters.

So you pop up your Bloomberg, and here’s what you see:

Even on trading, Vanguard wins on expenses. But Holy Meatballs Batman, what are those guys down in Pennsylvania doing!? A tracking error of 4.433 percent?

And at this point, many advisors will make a critical mistake, assuming that the Vanguard fund is horribly mismanaged. It’s not an unreasonable assumption, if in fact this was an accurate tracking error number. But it’s not.

Remember, academic tracking error is the annualized standard deviation of daily return differences. If the index is up 1 percent today, and VWO is up 0.95 percent, well, that’s -.05 percent to add to the series. Take that whole series, plug it into your stats package, get the standard deviation, annualize it, and there you go.

There are a few reasons this is all a terrible idea. First of all, imagine that VWO was actually missing its mark by 0.05 percent, day in and day out. Well, the standard deviation of those daily differences will be zero. It’s enormously consistent. Continue reading →