Article from June 13 edition, written by Maureen Nevin Duffy
Wall Street’s creative genius never runs out of new investment strategies for another exchange-traded fund based on one index or another. But in many cases, the funds barely reflect the actual securities in the indexes to which they are tied. In fact, many ETFs hold less than 10 percent of the components of the index they are marketed as representing. And critics say the returns of ETFs with what they call major “tracking error” can vary so much from those of the index as to be misleading.
Last March the technical committee of the International Organization of Securities Commissions, an international body of securities regulators, asked its members if regulators should make ETFs explain to investors how a new fund replicates its index and the degree to which its returns may vary. The comment period runs until late June.
“How 50 to 60 issues in an ETF will track 1,000 issues in a bond index is a good question,” says James Squyres, president of Buyside Research, a Darien, Connecticut–based research firm that analyzes ETFs based on the fundamentals of the securities they own. “Why not just create a fund with 50 to 60 issues and not track any index? What does tracking an index bring to the party?”
A well-known index can give a new fund instant gravitas and prospective investors a performance record on which to base their decisions. And skillful managers can use modeling techniques to produce index-like results in a fund without holding all the index components, thus saving a bundle in inventory transaction costs.
But tracking error can create big deviations between the fund’s annual returns and those of its benchmark. Firms applying to the SEC to create an ETF must state the maximum deviation they expect tracking error to produce, and that’s usually 5 percent. From 2008 to 2011, most ETFs stayed well below that ceiling, according to Lipper, with the exception of commodities funds, whose returns diverged by an average of 5 percent to 9.5 percent.
But analysts say other types of funds are subject to such divergence, particularly in fixed income.
As a rule, “a small universe of holdings highly diversified across a yield curve will result in high tracking error,” says Greg Davis, who heads up the bond indexing group for the Wayne, Pennsylvania–based Vanguard Group, a provider of mutual funds and ETFs. “Folks need to be careful since returns could be much less than the index performance would lead you to expect you’ll get.”
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