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Better Ways to Look at ETFs

Improved measures give investors a clearer view of ETF performance.

Michael Rawson, 08/08/2011

This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription today! 

Passive funds offer investors a tempting trade-off: no risk of substantial underperformance but nearly zero chance of exceeding the benchmark. In the other words, passive investors should expect near-zero alpha; returns should trail the index only by the disclosed expenses of the fund.  

In practice, things are not so clear. Passive funds certainly track their indexes much more closely than even the most diversified of active managers, but performance rarely matches that clean equation of index return minus disclosed expenses (Exhibit 1). Investors still need to be careful about choosing the right passive fund, and there are unique issues in measuring passive fund performance. Morningstar is introducing new data points--called Estimated Holding Cost, Tracking Volatility, and Market Impact--to help investors select the right ETF for their needs. But before we dive into these new measures, we first must explore how passive management should be assessed in theory. 

Long-Term Tracking Differences
Investors who hold funds for many years may not care much about random short-term deviations, but any predictable long-term drag against the index should be minimized. These drags can occur for a variety of reasons, but most come from trading costs that aren't included in disclosed management or administrative fees. These trading costs are a function of the turnover inherent in the tracked index (small-cap and non-market-weighted indexes require far more trading each year), the liquidity of the market in the underlying securities (blue-chip global equities will incur minimal trading costs, while trading credit bonds or emerging-markets stocks is far more costly), and a portfolio manager's scale and efficiency. Other funds use swap contracts to provide synthetic index exposure or currency overlays, which pay costly spreads to the issuing banks. On the positive side for shareholders, passive fund managers also generate share-lending and repurchase-agreement revenue on their fairly stable holdings.  

Trading costs, swap and derivative costs, and lending revenue persist from year to year, because they all depend on the policies and ability of the manager, as well as the nature of the index tracked. With this persistence in tracking ability, we should be able to look at index funds' return histories to identify the best performers, just as we do for traditional active funds.  

Short-Term Deviations
Traders, hedgers, and portfolio managers using exchange-traded funds to provide liquidity all care far more about the quality of portfolio tracking on a day-to-day basis than they do about long-term differences. Short-term deviations from the index could result from cash inflows and outflows, leaving a portion of the portfolio uninvested for a day or two. Similar timing issues can occur with dividend reinvestment if payouts take time to reach the portfolio, and dividend withholdings can cause payout sizes to differ from those assumed in the index. Finally, many passive funds tracking unwieldy fixed-income or broad equity indexes choose to follow an "optimized" or "sampled" portfolio by investing in a subset of securities that closely resembles, but does not perfectly replicate, the index.  

These short-term tracking errors also matter for long-term investors, though we cannot say beforehand whether these deviations from the index will be positive or negative. There's no way to know if the day that cash sits outside the market will be an up day or a down day, and daily return discrepancies have an average value that's near zero. However, small, accumulated short-term deviations could add up over time to bigger differences in trailing returns, so the average size of these daily discrepancies allows us to estimate the accuracy of our long-term tracking-difference measurements.  

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