ETFs are excellent building blocks for long-term portfolios given the inherent cost-efficiency and transparency benefits associated with this product structure. Nonetheless, like every other financial instrument, ETFs are far from perfect; tracking errors commonly occur, leaving investors wondering why they got one return, when the underlying index had another [Download 101 ETF Lessons Every Financial Advisor Should Learn].
An ETF, according to its prospectus, attempts to replicate an underlying index. How the fund chooses to replicate the index can vary from ETF to ETF, and may include investing in the underlying index, certain stocks, bonds and commodities, or creating a synthetic portfolio. Some ETFs also attempt to replicate the “daily performance” of an index—if the index is up 1 percent then the ETF will also be up very close to 1 percent–and while the fund fulfills this mandate, management fees, trading errors, hedging strategies, cash handling or poor management decisions may cause a diversion between ETF and index returns over the long-term. ETFs are also actively traded, which means investor demand or panic can push the price away from its fair value, called the Net Asset Value or NAV.
Here is a breakdown of the five largest ETFs by assets, and how they stack up relative to the index they are supposed to track.1. SPY
The S&P 500 SPDR ETF tracks the S&P 500 Index via the ticker symbol SPY. With one of the lowest expense ratios at 0.09%, fees are not a primary concern for investors in this ETF. The fund launched in January of 1993, and consistently has very high volume on a daily basis [see Visual History Of The S&P 500].
The ETF is suitable for those looking to gain exposure to large capitalization companies in the U.S. equity market.
Over the last several years SPY has done an excellent job of tracking the S&P 500 index. Based on the data, investors can expect SPY to perform in line with the S&P 500 overall.2. GLD
The SPDR Gold Trust tracks the price of spot gold via the ticker symbol GLD. It has an expense ratio of 0.40%, was founded in November of 2004 and consistently has excellent volume on a daily basis.
The fund is suitable for those looking for exposure to gold, whether as a speculative venture or to hedge or diversify their equity portfolio [see GLD-Free Gold Bug ETFdb Portfolio].
GLD has encountered discrepancies in performance over the last several years, relative to underlying gold performance. In some years GLD has outperformed, and in others underperformed. The difference is usually limited to plus or minus 1 percent to 2 percent. This may not be significant when returns are near 30 percent as they were in 2010, but is more noticeable when returns are smaller as they were in 2008. 3. VWO
The Vanguard Emerging Market ETF (VWO) is designed to measure the performance of emerging market equities. The fund has a 0.20% expense ratio and began trading in March of 2005. Since 2010, daily volume has regularly exceeded 15 million shares.
Investors in VWO are looking to gain exposure to equities issued within emerging market countries. The ETF has major holdings in several Asian countries, as well as emerging markets in Latin America, Europe, Africa, and small investments in the U.S. and Middle East.
|FTSE Emerging Transition Index||-52.90%||82.60%||19.80%||-19.00%||17.90%|
Given the sizable returns, both up and down, over the last several years, VWO has been within 1 percent of the underlying index return, with the exception of 2009. In that year, VWO underperformed the index by more than 7 percent. Since VWO does not invest in all the stocks listed on the index, but rather invests in a “sampling,” such errors can occur from time to time. This approach can also be beneficial, such as when VWO dropped less than the index in 2008 and 2011. 4. EEM
Also tracking emerging markets via the symbol EEM, the MSCI Emerging Markets ETF attempts to replicate the performance of the MSCI Emerging Markets Index. The fund has an expense ratio of 0.67%, began trading in April of 2003 and usually does over 50 million shares per day in volume.
EEM invests in international emerging market stocks, mainly in emerging countries within Asia, Latin America, Europe and Africa. EEM is a competitor to VWO, as they both are focused on emerging markets. Slight differences in the amount of funds allocated to various regions contribute to the variation in performance between the two funds [see Emerging & Frontier Markets ETFdb Portfolio].
|MSCI Emerging Markets Index||-53.18%||79.02%||13.21%||-18.17%||18.63%|
Since 2008, EEM has had multiple years in which its performance has varied by more 3 percent from the index, and in some years by much greater amounts. This has been beneficial to investors in certain years, and in other years it has been a detriment. Since the index does not invest 100 percent of its assets directly into all of the stocks that compose the underlying index, tracking errors similar to those seen over the last several years are expected to continue [try our Free ETF Country Exposure Tool]. 5. EFA
The MSCI EAFE Index ETF (EFA) tracks the performance of European, Australasian and Far Eastern equity markets. The fund seeks to replicate the performance of the MSCI EAFE Index, which, as of 2012, consists of 22 different developed market indexes. The expense ratio of the fund is 0.34%, it began trading in 2001 and since 2008 usually always does 15 million and more in daily volume.
Investors in this ETF are typically looking for exposure to well developed markets, outside of the U.S. The fund invests in large capitalization stocks from a wide assortment of sectors in Europe, Japan, Australia and Asia. A small percentage of the holdings (less than 1 percent total) are in the Middle East, Africa and Latin America.
|MSCI EAFE Index||-43.06%||32.46%||8.26%||-11.73%||17.90%|
The performance data over the last four years shows EFA has done well tracking the underlying index. The notable exception is 2009, where the fund underperformed by more than 5 percent. In 2008 though, the drop in EFA was 2 percent less than the drop in the index. Ninety percent of the fund’s assets are allocated to securities in the underlying index, which leaves room for continued tracking errors, but overall, EFA will track the general magnitude and direction of the index.Bottom Line
The largest ETFs by asset generally do a good job of tracking their underlying index. In any given year though, a divergence can occur. These differences in returns between the ETF and index can result from a large number of factors, including not having all funds fully invested, fees, changes in an index, investor demand, cash management or fund management strategies. Before investing in an ETF, make sure you feel comfortable that it is reflecting the index you expect it to. Reading the prospectus and comparing the ETF’s past performance to that of the index will help you make your decision.
Disclosure: No positions at time of writing.