When deciding which ETFs to use, advisers need to be skilled in assessing their replication quality by examining their tracking error and tracking difference, writes Ursula Marchioni of iShares.

The most important attribute advisers should consider when investing in exchange traded funds (ETFs) is the replication quality of these instruments, that is, how well the ETF’s performance tracks the performance of respective benchmarks.

Several indicators can be considered to assess the tracking quality of ETFs, the two main ones being the so-called tracking difference (TD) and tracking error (TE). TD is defined as the total return difference between a fund and its benchmark index over a certain period of time, for example, one year. It represents the realised underperformance (or cost) an investor suffers from (or overperformance an investor benefits from) when investing in an ETF, in comparison with a theoretical investment in the benchmark index.

TE is defined as the standard deviation of the difference in returns between a fund and its benchmark index. For example, over three years one could measure the month-on-month fund returns, and compare them with the equivalent index monthly returns.

This exercise would produce a series of 36 monthly return differentials – the standard deviation (or volatility) of which is the TE.

Why investment time span matters

TE is important to a tactical investor who trades in and out of ETFs on a regular basis, often holding an ETF for the period of only a few days or weeks. For a buy-and-hold investor with a longer investment time horizon, the TD is more important.

The main reason lies in the fact TE results from positive and negative differences between the fund and index performances. From month to month, an ETF may slightly underperform or outperform the reference index, but in the long run these differences should cancel each other out. While this netting is captured through the TD, it contributes to increasing the TE.

For physically replicating ETFs, one of the primary drivers of TD is the difference between fund holdings and index constituents. Cash management and trading costs from rebalancing can also have an effect on TD/TE. Importantly, the effect can be either positive or negative, depending on the underlying circumstances.

For example, if an ETF has excess cash during a market rally the fund would likely underperform the reference index. Similarly, excess cash would tend to cause outperformance of the underlying reference index in periods where the underlying market is falling (as a result, an ETF fund manager will always aim to hold a minimum amount of cash).

What is more, a fund’s tracking of its benchmark will be affected by differences in withholding tax applicable to investment income.

Finally, if the ETF engages in securities lending this activity will increase the TE, even though it will improve the performance of the fund.

Synthetic ETFs closely tied to swap spread

For synthetically replicated ETFs, one of the primary drivers of TD is the swap spread. The swap spread can be negative, which represents a cost for the ETF, being detracted from the index performance, or positive, which represents a source of revenue for the ETF, being added to the index performance.

An extra key driver of TD, for physically and synthetically replicated ETFs, is represented by the cost of investing in the instruments. This is strictly correlated to the underperformance of the fund versus its benchmark.

TERs can be opaque on total costs

The total expense ratio (TER) is often considered as the main indicator for the cost of an ETF. Owing to some of the points highlighted above, iShares advocates a more holistic assessment of the cost of investing into an ETF, based on the so-called total cost of ownership (TCO).

The TCO includes the TER and the swap spread mentioned above, together with other components the investor should consider, including rebalancing costs, securities lending revenue, as well as external factors, such as trading spreads, creation and redemption costs, brokerage fees, and tax.

Ursula Marchioni is a director at iShares.