In at the deep end with tracking error

Scott Longley

Perhaps to a surprising degree, when it comes to discussing ETFs it appears sometimes that only cursory attention is paid to the underlying index. These are, after all, purely theoretical constructs and as such any discussion around any given underlying index will tend towards the arcane.

To counter such thoughts, a paper issued by SPDR in December last year suggested that understanding the construction methodology of an index is "paramount" to evaluating the performance of any passive indexed product.

This is particularly the case with funds based on the wilder shores of index land, with the less efficient indices in areas such as emerging markets and high-yield bonds. As an example, SPDR took at two funds in the high-yield space and their underlying indices; the SPDR Bloomberg High Yield Bond ETF (JNK) and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG).

Looking at the performance figures of the two between 2010 and 2017, SPDR's analysts point out the HYG fund appears to approximate its index with greater precision with an average tracking error over the period of 0.40% compared to 1.17% for the JNK fund.

When the manner in which transaction costs are taken into account, though, the picture changes somewhat - and unsurprisingly in SPDR's JNK fund's favour. With HYG, transaction costs are calculated in two ways. Binds entering the index are accounted for on the offer side, which is higher than the bid price.

But at the end of each trading day, the bonds within the index are priced at the bid. Thus, on rebalance date the index performance reflects the natural drop in price from offer to bid - something that the ETF will also experience as it is transacted at the offer price but will use bid prices for NAV purposes.

More importantly, SPDR says, the HYG index includes a rebalancing cost factor, which further affects the index performance as it will now reflect the costs associated in rebalancing the index, "which can be considerable."

By way of contrast, the JNK fund tracks a Barclays index which, like most others from that source, follows a "common convention" and has all bonds enter the index on the bid side and does not include any adjustment for the monthly rebalance costs that the fund incurs.

To complicate matter further - and given the complexity involved here, we should say at this point in for a penny, in for a pound - as of June last year, all Bloomberg Barclays high yield indices have changed their pricing calculation for all new issue bonds entering their indices, and they will now be priced at offer not bid. The changes were not retroactive, so performance prior to the effective date remains impacted by the calculation difference as described.

To make what SPDR suggest is an apples-to-apples comparison, therefore, Barclays estimated the transaction costs associated with the monthly reconstitution of the index using a proprietary scoring system.

Using this system to defend the honour of its own index, Barclays determined that up to 69 basis points of the 1.17% tracking error can be accounted for - meaning, then, that the JNK tracking error would drop to 0.48% or a hair's breadth away from HYG's 0.40%.

One factor among many

Now, after saying all that, does it really matter to the average Joe, or even the average wealth manager?

SPDR think so, for obvious reasons. "Investors need to understand the construction methodology of the benchmarks within an asset class and how slight differences can have a major impact on perceived investment performance," they say.

Transaction costs can lead to a "vastly different performance measurements and an incomplete picture of how the fund is managed."

Peter Sleep, senior investment manager at 7IM, suggests transaction costs are one factor to keep an eye on. "With caveats, there is no real economic impact on a physical ETF about how an index treats transaction costs but it does have an impact when calculating tracking error or tracking difference, which may be important in the purchase decision for investors," he says.

But there are other issues that are higher up the chain of importance, he adds. "I suspect the most important factors for investors are compliance with the relevant regulations, availability (for retail investors investing via an on-line platform), cost and size/liquidity. The niceties of index compilation are further down the list."

But importance isn't the only issue. As can be guessed from even the brief description above, index methodology documents are "long and turgid."

"Even if you do read these documents it is hard to assess the impact of various measures taken unless you are intimate with the market concerned and the impact of the rules adopted by the index. This therefore makes it difficult for nearly everyone to understand bespoke indexes."

SPDR conclude that index due diligence is "critical" to assessing the true efficiency of the passive approach. Which is likely true. But how much the average wealth manager or their clients has fully bought into that level of enquiry is, we would suggest, more open to question. Whether that might change is another estimate that, to put it plainly, will come with six-lane highway of margin for error.

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