ETF Mechanics And Tracking Error

Exchange traded funds (ETFs) represent shares in an index tracking (i.e., benchmark) portfolio that trades on secondary markets. While similar to mutual funds, significant differences remain with respect to costs and taxation. While most ETFs are based on direct investments in underlying securities, ETFs can also utilize derivatives, invest via American depositary receipts (ADRs), or use leverage.

The issuer (i.e. sponsor or manager) of the ETF allocates the portfolio based on the stated index/style and stands ready to redeem or create new shares in kind.

Unlike open end mutual funds, ETFs are traded on secondary markets. Therefore, when a shareholder wants to cash out, the shareholder sell his shares at the exchange where the ETF is traded; the ETF issuer is not involved in this transaction.

The ETF issuer designates authorized participants (APs). APs are large broker- dealers that make the market in that ETF as primary market participants. APs are permitted to create additional shares, or redeem existing shares, for a service fee payable to the ETF manager.

This creation/redemption process is in kind: APs deliver a basket of securities (which may include cash) to the issuer in exchange for a number of ETF shares. They may also redeem ETF shares for a basket of securities. The ETF manager publicly discloses the list of required in kind securities, known as the creation basket, each business day.

The creation basket serves as a key input in determining the net asset value (NAV) of the ETF. A related term is the redemption basket, which is the specific assortment of securities that the AP receives upon redeeming an ETF share.

The lot size in these primary market transactions is the creation unit; an ETF issuer specifies the size of a block of ETF shares (commonly 50,000) that can be traded as part of this creation/redemption process.

The in kind creation/redemption process serves three purposes:

1. Lower cost: The creation/redemption process does not force the ETF manager to sell/purchase portfolio investments; the manager does not incur any resulting transaction cost. The ETF manager usually collects a service charge from the AP to cover any incidentals. 2.

Tax efficiency: A major benefit of the in kind creation/redemption process is that it is not a taxable event. For a mutual fund, liquidity needs for redemption are often met by the fund manager by selling some of the fund’s holdings, which triggers transaction costs as well as potential capital gains taxes. These costs are borne by all the shareholders of the fund (including those that did not redeem shares).

Additionally, ETF managers can choose to publish customized redemption baskets, allowing them to target low basis stocks that will be part of the redemption basket. This increases the tax efficiency (i.e., increases the basis) of the remaining holdings of the ETF.

1. Keeping market prices in line with NAV: APs will engage in arbitrage transactions if the ETFs trade at a price significantly different from their NAV. If the ETF trades at a premium, APs can sell the ETF, purchase the creation basket, and recreate those shares.

Similarly, if the ETF trades at a significant discount to NAV, the APs can purchase the ETF and redeem the shares.

It should be noted that APs incur transaction costs in creating the creation basket (or selling the redemption basket) in addition to any service fees that the ETF manager charges for creation/redemption. This implies that ETFs should trade within a price band of the NAV, known as the arbitrage gap. Because the liquidity of the securities in the basket determines the transaction cost, the arbitrage gap tends to be wider for ETFs with illiquid holdings.

Due to difference in time zones, an ETF on a foreign index may exhibit a difference between its NAV and the last closing price when the foreign market was open. This timing difference increases risk for the AP, leading to a wider arbitrage gap. Similarly, ETFs with underlying illiquid securities (e.g., corporate bonds) would also have a wider arbitrage gap, because of the market risk borne by the AP during the time it takes to complete the trade.

APs pass on these costs in the form of bid ask spreads on ETFs, which means that only transacting shareholders pay these costs, unlike with mutual funds where all shareholders bear this cost. Similarly, unlike mutual funds, ETFs are tax fair because redemptions are in kind and do not affect the nontransacting shareholders.

ETFs trade on secondary markets just as stocks do. In the United States, the National Security Clearing Corporation (NSCC) guarantees the performance of parties to a trade on an exchange. The Depository Trust Company (DTC), a subsidiary of NSCC, transfers the securities from the account of the seller’s broker to the account of buyer’s broker at the end of the two day settlement period.

Individual client level ownership records are maintained by the brokers. Market makers, due to their special significance, and due to the time required by the creation/redemption process, are afforded up to six days to settle their trades.

European markets are fragmented across many exchanges and countries, and ETF investors there tend to be mostly institutional investors. A majority of ETF trades occur in the over the counter (OTC) markets, without “live” bid and offer prices. Most European ETFs are listed on multiple exchanges and may have multiple classes.

With 29 central depositories in Europe, the added complexity in settlement may widen the quoted bid ask spreads.

Tracking difference is the divergence between an ETF’s return (based on its NAV) and the return on the tracked index. This measure provides an indication of the ETF’s ability to follow its underlying benchmark. Tracking error is the annualized standard deviation of the daily tracking difference.

Calculated as a standard deviation, tracking error does not indicate whether the ETF under- or outperformed the index, nor does it reveal the distribution of relative differences in return (i.e., whether the tracking difference occurred over time or was concentrated in a specific period).

As opposed to daily tracking difference, rolling holding periods allow us to evaluate the cumulative effect of portfolio management and expenses over a longer time period. Annual rolling holding period can be compared to an ETF’s expense ratio; ETFs generally underperform the benchmark by their expense ratio.

Sources of tracking error include the following:

1. Fees and expense. Fees reduce a fund’s return. 2.

Sampling and optimization. ETFs may use statistical techniques to replicate the performance of a benchmark without investing in all the securities that the index covers. Optimization techniques often favor higher liquidity securities (and larger market cap companies) to minimize transaction cost.

As a result, the ETF may impart a size bias relative to the benchmark. 3. Depository receipts (DRs). Foreign index ETFs often invest in DRs (rather than less liquid securities traded on local exchanges).

Any difference between the price of DRs and corresponding security (e.g., due to time zone differences in capturing price data) may contribute to tracking error of the ETF. Furthermore, sometimes an ETF may invest in other (sector) ETFs, and thus inherit the tracking errors of those ETFs. 4. Index changes.

Index providers will occasionally rebalance or reorganize their indexes. ETF managers often use the creation/redemption process to rebalance the ETF portfolio to reflect this change in the index. The resulting delays from the use of the creation/redemption process contributes to tracking error.

Because changes to an index are relatively infrequent, this component is often the smallest contributor to total tracking error. 5. Regulatory and tax requirements. In some countries, tax rates for foreign investors and domestic investors differ, leading to a difference in after tax returns between an ETF and the index that it tracks.

1. Fund accounting practices. The time of the day when ETF NAV is calculated versus when the index provider performs this computation can lead to differences in calculated returns.

Additionally, ETFs with foreign currency denominated holdings may use exchange rate values captured at a different time than the rate used by the index provider. 7. Asset manager operations. ETF managers may try to lower their cost by lending their shares to short sellers, and by foreign dividend capture (i.e., by working with foreign governments to minimize the taxes on distributions received).

These methods tend to improve ETF performance relative to their benchmark.