When investing in ETFs there are many things to consider when choosing an ETF to represent a particular asset class or investment category. Costs, both explicit and implicit are important to consider and these costs should be taken into account.

Exchange Traded Funds (ETFs) have been hailed because of transparency, tax efficiencies, and especially low cost. With no other investment vehicle can an investor invest in a diversified fund as quickly and cheaply as with ETFs.

The uses of ETFs are broad and range from institutional investors, day traders, and investors saving for retirement and generating income in retirement.

More than just the expense ratio of an ETF, other factors should be reviewed and considered. Almost as important as how expensive it is to access an index through an ETF is how efficient the ETF is at providing the access. This is really the more important factor when comparing similar products.

The Tracking Error Cost

ETFs track indexes. They do this by first having a Net Asset Value (NAV) created by the ETF issuer that tracks the index. The NAV is than tracked by the market price of the ETF. So there are two causes of an ETF not tracking its benchmark. One problem is the premium/discount that the ETF is trading at around the NAV. This is much like how closed-end funds trade at premiums and discounts. The premium/discount of an ETF is the fault of the market not taking advantage of opportunities in the price of the ETF and the actual value of the NAV of the fund. In normal market conditions the premium/discount is usually low. In illiquid markets, like bonds during a credit crisis (like the one of 2008) there is no transactions taking place and the bond prices on the books do not reflect actual market value. In this situation, ETFs become the liquid market for the bonds and reflect actual market values. In the case of the 2008 credit crisis, bond ETFs saw huge discounts to NAV. The problem was at first thought to be with the ETFs, but at closer inspection, the ETFs were actually putting in fair market value for the underlying bonds.

The second way ETFs fail to track the market is through tracking error, which is how well ETF market prices vary from the NAV of the fund. Tracking error is in control of the ETF issuer and is the purpose and objective of the manager and ETF to track as closely as possible.

Tracking error is what separates good ETF managers from poor ETF managers. In this way tracking error seems like a cost to the ETF investor. The explicit cost of an ETF is the expense ratio. However, in some instances it is the tracking error, an implicit cost, which has a greater impact on the ETF and its performance.

When we study the emerging market ETF space, tracking error has made a big difference. The two ETFs, The Vanguard Emerging Market ETF and iShares MSCI Emerging Market Index Fund, EEM both track the MSCI Emerging Market Index. The Vanguard ETF charges a dirt cheap .27% while iShares charges .72% for tracking the same index. This is a big difference for doing the same thing.

The difference between the two funds is one uses index optimization and one invests in almost all the indexs holdings.

Looking at the last quarter of 2008 through 3/25/2009 we can see the difference iShares, through its optimization of the indexs holdings had on relative performance to the index and overall return.

IShares optimizes its ETF so it will not be investing in the most illiquid of the securities. Over a short period of time, the iShares EEM performed better than its index and lower cost peer, The Vanguard VWO. However, this does not mean EEM will always outperform, but it is to say that tracking error has a greater affect of ETF returns than expense ratios.

Analyzing the difference

There are many comparable ETFs on the market, competing on the cost level, because cost is important and a main reason many investors shift assets from index mutual funds to comparable ETFs. When analyzing the differences between ETFs tracking similar indexes, cost matters less than tracking error. Tracking error measures how well the ETF provider is at tracking indexes, which is what investors are paying for. In the long run, ETF costs matter but tracking errors matter more, affecting the performance by a greater amount.

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