When it comes to exchange traded fund (ETFs) performance all you should care about is tracking difference, right? Wrong. ETFs are designed to hug underlying indices and whether they end up at the same point as an index is important, but how well they track that index over time and the cost of trading them all have impacts on your returns. So how do you know who's best?
ETF provider Lyxor has devised a new way of ranking ETF performance in a single score, combining tracking error, tracking difference and liquidity in order to rank the products with the best track record of hugging an underlying index with the lowest cost impacts on returns.
How does it work?
"We wanted to look at efficiency as the total cost of owning an ETF from buying to holding to selling," says Ben Thompson, business development director at Lyxor.
"Tracking difference is an annual measure which says at the end of the year where did you end up versus the index and it shows you if you're holding long term the amount you would expect to lose, which is largely made up of the TER (for an ETF tracking perfectly, the ongoing cost of the product should be the only difference in return between index and benchmark).
"That's all fine but if you sell during the year your performance could be higher or lower and you could be closer or further from your benchmark. You really want to make sure you're also tracking that index on a day-to-day basis as well and progressively trending towards the tracking difference towards figure the end of the year," he adds. Tracking error is a measure capturing the volatility of ETF performance and is often forgotten about by investors in favour of tracking difference but it is an important metric.
"Those were the first two parts of the equation. The last part was about saying you've bought and held this product but now you want to sell it and that's about having a narrow bid/ask spread. If you have a very illiquid fund you will have a massive gulf between the buy and sell price."
Lyxor then combines those three metrics into a single score. The more positive the number the better and more efficient the product. In its most recent report it has compared 10 key equity benchmark indices, counting for around 40 per cent of assets invested on the European ETF market. For each index the group has created a 'peer group' made up of the relevant Lyxor products and four largest ETF share-classes issued by other providers.
Who's on top?
According to Lyxor's most recent report into ETF market efficiency, the most efficient product is db x-trackers MSCI USA Index UCITS ETF (XMUS:GY). It is also available on the London Stock Exchange (XDUS).
The two best indices for ETFs to track are the Euro Stoxx 50 and S&P 500, which have the highest efficiency measures for ETFs tracking them.
According to Marlene Hassine, head of ETF research at Lyxor, the European equity ETF market has improved by 18 basis points over the year as a result of popularity and high competition to deliver strong performance.
She says: "The Euro Stoxx 50 indexation offers the highest level of efficiency while, unsurprisingly, the emerging market indexation has the lowest efficiency level but has experienced the highest improvement over the past two years."
Lyxor and iShares demonstrated the best scores for the S&P 500 and Euro SToxx products, with iShares Euro SToxx 50 UCITS ETF (EUE) achieving an efficiency score of 0.7 per cent, made up of a 0.16 per cent TER, 1.32 per cent tracking difference, 0.1 per cent liquidity spread and 0.3 per cent tracking error.
Lyxor's S&P 500 UCITS ETF also performed well, making top ranking for the index with a score of 0.23 per cent with a tracking error of 0.01 per cent and tracking difference of 0.32 per cent. The ETF is traded in Frankfurt but is available on the London Stock Exchange in a dollar denominated share class.
What should you look out for?
This measure is by no means the be all and end all but it does demonstrate the importance of looking at all the costs of your ETF, not just the TER and tracking difference figures. ETF providers are under increasing pressure to push down costs as more and more entrants come into the market but cheaper does not always mean better.
"TER is just one of three parts of the cost," says Mr Thompson. "You need to think about these three things. Cheap does not always mean best. If you buy a cheap ETF with a massive spread you're giving up efficiency. If you buy a cheap ETf which tracks badly on the short term then you're giving up performance."
Top five indices and top ranking ETFs
| Index | Index performance (total return EUR) | Effiency indicator ranking and top ETFs | |||
| Rank 1 | Rank 2 | Rank 3 | Rank 4 | ||
| Euro Stoxx 50 | 3.93.% | iShares | Lyxor | Deka | DB X |
| 0.7% | 0.4% | 0.3% | 0.3% | ||
| S&P 500 | 29.5% | Lyxor | Vanguard | iShares | DB X |
| 0.2% | 0.2% | 0.2% | 0.1% | ||
| MSCI USA | 29.2% | DB X | Lyxor | Amundi | Comstage |
| 0.0% | -0.1% | -0.1% | -0.2% | ||
| MSCI Europe | 7.2% | Lyxor | Amundi | iShares | DB X |
| 0.0% | 0.0% | -0.2% | -0.3% | ||
| MSCI World | 20.3% | iShares | Lyxor | DB X | iShares |
| -0.2% | -0.2% | -0.3% | -0.4% | ||
Source: Lyxor ETF
