Train off the Tracks

I was reading Investment Advisor Magazine the other day when I saw an article titled, “Despite Growth, More ETFs ‘Jump the Track’” and I thought to myself how could an ETF jump the track? Is that like jumping the shark?  Well, as it turns out the term, jump the track, has very little to do with popularity and rather focuses on how far off the ETF is from its original index tracking purpose.

What is an ETF? What is the Purpose of an ETF?

InvestorWords has a pretty complete definition for most ETFs,

A fund that tracks an index, but can be traded like a stock. ETFs always bundle together the securities that are in an index; they never track actively managed mutual fund portfolios (because most actively managed funds only disclose their holdings a few times a year, so the ETF would not know when to adjust its holdings most of the time). Investors can do just about anything with an ETF that they can do with a normal stock, such as short selling. Because ETFs are traded on stock exchanges, they can be bought and sold at any time during the day (unlike most mutual funds).

Their price will fluctuate from moment to moment, just like any other stock’s price, and an investor will need a broker in order to purchase them, which means that he/she will have to pay a commission. On the plus side, ETFs are more tax-efficient than normal mutual funds, and since they track indexes they have very low operating and transaction costs associated with them. There are no sales loads or investment minimums required to purchase an ETF. The first ETF created was the Standard and Poor’s Deposit Receipt (SPDR, pronounced “Spider”) in 1993. SPDRs gave investors an easy way to track the S&P 500 without buying an index fund, and they soon become quite popular.

So if we are tracking an index then one would think it would be in line with index minus fees?

How does an ETF Jump the Track?

As highlighted by Investment Advisor Magazine there are several ways a tracking error can occur:

    • Some ETFs use a methodology of full replication, in which all the index constituents are owned in their proper proportion, but full replication would be too costly for other indexes, and managers opt instead to use representative sampling to achieve a similar result.
    • Index members also change, and it is not always possible for the portfolio to match each change simultaneously.
    • Furthermore, there are some ETFs that track indices whose weightings conflict with the portfolio diversity requirements mandated by the Securities and Exchange Commission.
    • For equity funds, how the fund handles dividends can lead to tracking error, as well.
    • international and global ETFs tend to have the largest tracking errors…because the underlying markets are more difficult to access
    • Emerging market ETFs were a particular problem, accounting for seven of the nine international ETFs with the largest tracking error and trailing their target index by an average of 836 basis points.

Examples of an ETF Jumping the Track

Early last year the Wall Street Journal provided some pretty powerful examples of ETFs jumping the Tracks:

    • …the $40 billion iShares MSCI Emerging Markets Index ETF (EEM) returned 71.8% in 2009, lagging the 78.5% return for its benchmark by 6.7 percentage points.
    • The $3.7 billion SPDR Barclays Capital High Yield Bond ETF (JNK) posted a return of 50.5% versus 63.5% for the index it tracks, trailing by about 13 percentage points.

Jumping the track doesn’t seem as wide spread for the massive wide spread ETFs like SPY who was within .19% of the index for 2009 and obviously if the index can miss the index one way it can miss the other returning more than the index.

Have you ever checked your ETFs to see if they jumped the track? Do you own ETFs or Mutual Index Funds? Have you ever heard of this term?