Thousands of exchange traded fund (ETF) and tracker fund investors are being short-changed as a result of additional and sometimes unexplained costs, collectively known as 'tracking difference'.
Tracking difference is the long-term gap created when an ETF or a tracker fund either over or underperforms its benchmark index. The average tracking difference for ETFs ranges from about 4 to 21 basis points a year, according to data provider Morningstar (1 basis point = 0.01 per cent). Last year it reported average tracking difference was getting smaller, but Investors Chronicle research has found a number of popular funds with abnormally large tracking differences.
Some passive funds have much wider tracking differences than others, which means it’s important to check tracking difference when choosing a fund. Big tracking differences are more common in exotic markets as the benchmarks are harder to track. Emerging markets indices, for example, are very complex (spread across many time zones, there are different tax rules and many of the countries are illiquid and therefore difficult to buy and sell in.)
The tracking difference on the iShares JP Morgan Emerging Market Bond ETF (EMBE) is particularly wide. Since 2009, tracking difference figures show investors have achieved returns that are 8.20 per cent below the benchmark index - showing a true cost of well over 1 per cent a year.
But this doesn’t mean you can get complacent if you’re investing in markets closer to home, according to Peter Sleep, ETF specialist at Seven Investment Management, as there are some exceptions.
Investors who bought iShare’s FTSE 100 Income ETF (ISF) in 2009, for example, would by now have paid 4.36 per cent out of their returns, its tracking difference indicates (according to figures from Bloomberg). The ETF’s total expense ratio (0.4 per cent a year) makes up less than half of these costs, showing the importance of looking beyond just the basic charges of UK funds.
The largest single contributor to tracking difference is fees, with Morningstar research showing that charges account for over 50 per cent of tracking difference. Other sources of tracking difference include withholding tax, particularly in Europe, the costs of rebalancing the components to reflect the benchmark being tracked and cash received from dividends - known as 'cash drag'.
So, particularly if you're a long-term investor, tracking difference is as important as the fees you pay to be in the fund. You won't know the total costs of buying it if you can't see the tracking difference, so, in other words, checking tracking difference is essential.
How is tracking difference different to tracking error? Don't confuse tracking difference with tracking error (sometimes shown on an ETF's fact sheet), which most investors don't understand properly. Tracking error measures how much the difference in the index performance and the fund performance fluctuates over time. However, tracking error measurements can have no bearing on actual investor experience. For example, if an ETF missed its mark by 0.05 per cent day in, day out, the tracking error would be zero. But if that index had stayed flat for a year you would have lost out by 12 per cent. What most investors care about is long-term buy-and-hold returns, and for these investors tracking difference is the measure to watch. |
Many ETF providers disclose tracking difference figures in their fact sheets, but not all of them are so transparent. Fresh Morningstar research reveals that ETFs are generally succeeding in reducing tracking difference, but there are some exceptions.
Why do some ETFs have positive tracking differences?
If performance enhancement activity goes beyond cancelling out the management charge, then the fund will register slight outperformance. This is called positive tracking difference. For example, iShares USD HY Corporate Bond ETF has a positive tracking difference of 1.28 per cent since September 2011. The possibility of the fund generating positive tracking difference relates to the extent to which the fund can utilise performance enhancement activities. For example, ETFs that use physical replication to replicate the index can make money by lending out for a short term a portion of the physical securities held by the fund.
How do I find out the tracking difference of a fund?
The first place you should look is the fund fact sheet, but unfortunately not all funds disclose tracking differences here. In fact, most choose to disclose either tracking error or tracking difference, according to which flatters them the most. And it's not always the latter, so be aware of this. However, new regulations introduced this year mean providers do have to include both tracking error and tracking difference in their annual report, which you can find on their websites.
ETFs performance and tracking difference
| ETF | 5 year tracking difference | 1 year annualised performance (%) | 3 year annualised performance (%) | 5 year annualised performance (%) | TER (%) |
| iShares JP Morgan Emerging Market Bond ETF (SEMB) | negative 8.2% | -15.34 | 0.14 | 1.89 | 0.45 |
| iShares FTSE 100 Income ETF (ISF) | negative 4.36% | 4.63 | 8.41 | 14.87 | 0.4 |
| iShares USD HY Corporate Bond ETF (SHYU) | positive 1.28% (since 2011) | -9.25 | 0.5 |
