21782 mots 88 pages
Quantitative Research

Index Research Global

06 September 2010

Global Markets Research

Global Equity Index & ETF Research

Data in this report is as of Aug 20th, 2010

Do ETF trackers track? European equity ETF tracking error under the microscope
When investors purchase index products such as ETFs, they have a very set and, seemingly, simple goal in mind: they expect them to track their stated benchmark, as closely as possible. This very specific investor expectation often raises the product evaluation bar and can even create undue expectations. Therefore, analyzing and understanding the dynamics that drive this very fine tracking balance is close to many investors’ heart. Tracking error (TE) is perhaps the most popular measure of how well an ETF is performing against its benchmark. And while less TE is generally better than more TE, it is important to consider that mistracking can come not only in the form of underperformance but also in the form of outperformance. [Relative to an ETF’s benchmark]. Thus, while it is important to measure TE, it is also critical to understand its sources. The most evident and quantifiable source of mistracking comes from management fees but that information is typically readily available and therefore easier to evaluate. Hence, it is more important to look beneath the surface, decompose an ETFs return stream and detect other possible sources of mistracking as well as resultant risks and benefits. Such information can enable investors to make much more effective beta investment decisions as well as give them a more insightful perspective in how to evaluate an ETF product. Benchmark underperformance is more immediately accepted as an index product flaw, however, our study has revealed that outperformance can also disguise information which is equally important to consider. A set of ancillary investment activities, which always fall within an ETF’s investment mandate, as well as market driven events, can both benefit or

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