Investments

First, there has been unbelievable growth in the creation and distribution of ETFs in recent years. Last year alone, there were nearly 300 new ETFs launched, roughly doubling the number of ETF options now available to investors. Most of these new ETFs are in more exotic asset allocation classes, sectors of the market and investment styles. Some of them are even “actively managed” ETFs. As a result, fees and trading costs on average are on the rise across portfolios constructed with ETFs. We have found that it is crucial to focus a fund’s trading costs and fees now as a negative drag on performance – more so than in years past where ETFs were primarily in the largest asset class categories with very minimal fees and costs. In fact, just a few years ago, ETFs were promoted as a less expensive approach to indexing as compared to their index mutual fund cousins. That advantage is certainly eroding.

Second, in periods of market stress we have seen another area of tracking error emerge. This relates to the underlying assets held and the fund’s “liquidity” to the market. With more and more ETFs being introduced and a movement into wider asset classes and styles, this has impacted the actual holdings in each ETF. And, where trading and “synthesizing” of the underlying portfolio of holdings is appropriate given availability of stocks and timing issues, we are seeing smaller more niche ETFs attempt to optimize their relative index as opposed to simply following it. For the ETF managers in these smaller more niche asset classes, it may be difficult (and at times impossible) to completely replicate the desired index given trading availability, timing and limits on security holdings for funds. And, as you would expect, the dispersion of returns starts to widen as a result – good and bad. This is especially true in sector-based ETFs where one particular company could be so large it could bump above the maximum holding requirement of 25% of the fund for a particular issue. As volatility increases in the market, it makes the difference between the ETF’s holdings and the indexes more pronounced.

In the end, we believe that investors should be aware of the fact that an ETF’s performance can diverge from the relative index, especially as more and more portfolios are constructed using ETFs across asset classes. The data in recent years show a trend toward increasing tracking error as investments move out of the efficient frontier. Tracking error for fixed income ETFs is the lowest and highest for International and emerging markets, sometimes even well over a percentage point of variance depending upon the fund. And, as more and more ETFs are created, with ever increasing sophistication over the constructed index to be replicated, we see this trend toward overall tracking error increasing, not decreasing in the years ahead.