A passive tracking ETF aims to replicate the returns of an index by investing in the components of the index. For STI ETFs, the purpose is to invest in STI component stocks and achieve the STI returns as closely as possible. The index is mathematically devised and the calculations have excluded many slippages and imperfections in the real world. These imperfections affect the accuracy of the ETFs tracking the indices. SPDR STI ETF prospectus has acknowledged the possibility of tracking errors,

Changes in the Value of the Fund are unlikely to replicate exactly changes in the Straits Times Index. This is due to, amongst other things, the fees and expenses payable by the Fund, transaction fees and stamp duty incurred in adjusting the composition of the Fund’s portfolio to reflect changes in the Straits Times Index and dividends received, but not distributed, by the Fund. In addition, as a result of the unavailability of Index Shares, the transaction costs in making an adjustment outweighing the anticipated benefits of such adjustment, or for certain other reasons, there may be timing differences between changes in the Straits Times Index and a corresponding adjustment to the composition of the Fund’s portfolio. During times when Index Shares are unavailable or when the Manager determines it is in the best interests of the Fund to do so, the Fund may maintain a small cash position or invest in other permitted contracts or investments until Index Shares become available. The Fund may also hold Future Index Shares and/or Former Index Shares. Such costs, expenses, cash balances, timing differences or holdings could cause the Fund’s Value to be lower or higher than the relative level of the Straits Times Index.

Similarly, Nikko AM also stated,

Various circumstances may make it impossible or impracticable to purchase each component Index Share in the same weightings as reflected in the Index. In those circumstances, the Manager may employ a combination of one or more investment techniques in seeking to closely track the Index. In addition, given that Index Shares may be and are added to or removed from the Index from time to time, the Manager may sell or purchase securities that are not yet represented in the Index in anticipation of their removal from or addition to the Index.

I have identified 4 possible tracking errors below.

#1 Replication Challenges

The most significant deviation from the index is trying to replicate the index with actual stocks. It is especially challenging when STI component stocks are replaced, or the weightage of the component stocks are adjusted, during the review of STI. These funds are big and a change in a component stock will result in large buy and sell orders. These orders in turn alter the prices of the stocks being added and deleted from the index. If the cost runs up too much, the Funds will naturally perform poorer than the index returns. In this aspect, the Fund Managers may buy and sell stocks in anticipation, or even use Futures contracts to avoid pushing the prices around.

SPDR STI ETF prospectus stated,

The Manager will generally invest the Fund’s assets in all of the stocks comprising the Straits Times Index in the same approximate proportion as their weightings within that index. However, various circumstances may make it impossible or impracticable to purchase each component stock in such weightings. In those circumstances, the Manager may employ, alone or in combination, other investment techniques in seeking to closely track the Straits Times Index. In addition, given that stocks may be and are added to or removed from the Straits Times Index from time to time, the Manager may sell stocks that are represented in the Straits Times Index, or purchase stocks that are not yet represented in the Straits Times Index, in anticipation of their removal from or addition to the Straits Times Index. In particular, the Manager may invest the Fund’s assets in Futures Contracts and options in order to try to minimise tracking error between the Straits Times Index and the Value of the Fund.

Unlike SPDR STI ETF, Nikko AM will not engage in derivatives to replicate the index. The Nikko AM STI ETF propspectus stated,

The Fund will not invest in warrants, commodities and precious metals.

The Fund does not use or invest in any financial derivative instruments.

The Manager will rebalance the Fund’s portfolio of investments from time to time to reflect any changes to the composition of, or the weighting of securities in the Index with a view to minimising tracking error of the Fund’s overall returns relative to the performance of the Index. Such rebalancing may be in the form of investments in non-Index Shares. Imperfect correlation between the returns of portfolio securities and the Index is more likely to happen to the extent that the Fund invests in securities that are non-Index Shares or invests in those Index Shares with different weighting from that of the Index.

#2 Transaction Costs

When the Managers incur brokerage fees when they buy and sell the stocks. These fees are absent in the calculation of STI. Frequent buying and selling of stocks will increase the tracking error of the funds. Higher brokerage fees will also mean higher tracking error too. Fund managers should have been charged lower rates to reduce the transaction costs as much as possible.

#3 Dividends

STI ETFs pay about 3% dividends annually. This accounts for 30% of STI ETF returns. Although STI returns include dividends, STI ETFs tend to OUTPERFORM the index after with actual dividends. See below for SPDR STI ETF annual returns for the period of Jul 03 to Jul 13:

• Index (without dividends) = 7.53%
• SPDR STI ETF (Without dividends) = 7.48%
• SPDR STI ETF (With dividends reinvested) = 10.73%

The dividends are used to pay the following expenses, and hence, the STI ETF underperforms the STI.

#3.1 Taxes

Tax is not exactly a tracking error because taxes are deducted from the dividends received by the Funds. These dividends are deemed as income for the fund management companies and hence, they are subjected to 17% corporate tax. Since the dividends cause the ETF to outperform the Index, taxes serve to minimise the tracking error by reducing the dividend payout.

#3.2 Fund Management and Trustee Fees

Similar to taxes, fund management and trustee fees are not tracking errors in this case because these fees are low and can be adequately covered by the dividends received from the stocks held by the funds.

#4 Bid and Ask Spread

Traditionally, the value of Unit Trusts and Funds are quoted in Net Asset Value (NAV). When you buy or sell a Fund, you pay or receive the price according to the quoted NAV. The NAV is fixed for the whole day and updated on a daily basis. ETFs are traded like stocks on the exchanges and they are subjected to bid and offer prices from investors. Investors determine the prices they are willing to transact. Hence, these prices may deviate from the NAV and increase the tracking error. Nikko AM STI ETF Prospectus stated the following:

The NAV of the Fund represents the fair price for buying or selling Units. As with any listed fund, the secondary market price of Units may sometimes trade above or below this NAV per Unit. The deviation from this NAV is dependent on a number of factors, but will be accentuated when there is a large imbalance between market supply and demand for Units on the SGX-ST.

In addition to buying and selling STI ETF over the exchange, investors can purchase blocks of 100,000 units in Nikko AM STI ETF or 500,000 units in SPDR STI ETF. These units will be quoted at NAV and not based on the bid-ask prices on the exchange. There is some market-making opportunities if bid-ask spread deviates from the NAV by a good margin.

[From Nikko AM STI ETF Prospectus]: Investors in the Fund who wish to purchase or sell less than 100,000 Units will have to acquire or dispose of their Units (as the case may be) through trading on the SGX-ST. These features are different from the features of conventional unit trusts where units can be purchased and redeemed by the investors for cash from the Manager on each Dealing Day in comparatively smaller multiples of units. The arrangements for creation and redemption of Units in multiples of Creation Units or Redemption Units as applicable, or blocks of 100,000 Units by or through Participating Dealers are designed to protect investors from the adverse effects which arise from frequent cash subscription and redemption transactions that affect the NAV of conventional unit trusts. It is also designed to help to keep the trading price of the Units close to the NAV of the Units.

What is the degree of tracking error?

The degree of tracking error is acceptable for both STI ETFs. SPDR STI ETF has stated in their factsheet that their annual tracking error is 0.66% while Nikko AM STI ETF has an annual tracking error of 1.01%. Nikko AM has fared slightly worse in terms of tracking error but it might be due to her short history. In the short run, tracking error is expected to be higher and this error will revert to the mean over a longer period of time. Hence, given more years of performance, SPDR STI ETF has a smaller tracking error. At this point in time, we cannot determine if the employment of futures contracts by SPDR to minimise tracking error is indeed a better strategy. We need to give Nikko AM STI ETF another 5 to 7 years to stabilise their tracking error.

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