What is the true test of an exchange-traded fund's success? Believe it or not, it's not whether it makes investors money or not. Success for most ETFs lies in their ability to replicate the returns of the underlying index they were created to track.
For example, Vanguard's Total Bond Market ETF (nyse: BND), which is designed to replicate the returns of Barclay's U.S. Aggregate Bond Index, had a total return in 2008 of 5.2%. That was only five basis points (or five one-hundredths of a percentage point) different--in this case, better--from the underlying index's total return.
In Pictures: 20 Worst Index-Tracking ETFs
In Pictures: 20 Best Index-Tracking ETFs
Factor in Vanguard Total Bond Market ETF's 11 basis points in expenses, and Vanguard's Total Bond Market ETF had a total return in 2008 only six one-hundredths of a percentage point below its benchmark index. That's stellar performance in the world of exchange-traded funds.
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Dominic Maister, exchange-traded fund analyst for
"The SEC diversification rule mandates that certain funds can have no more than 25% of their assets in one security," says Maister.
For the purposes of his study, Maister excluded certain gold and silver tracking ETFs as well as inverse and leveraged ETFs that have gained widespread popularity in the declining market. These funds come loaded with surprises all their own. Inverse and leveraged ETFs are designed to replicate the daily performance or opposite daily performance of their underlying index. This means these funds effectively reset every trading day, potentially causing wildly unexpected returns for buy and hold investors who thought they were merely making an opposite bet on an underlying index.
For example, anyone buying and holding ProShares Ultrashort Financials would have gained 4.3% in 2008, versus a decline of 50% for the Dow Jones U.S. Financials Index. Since the fund seeks to double the opposite of the Dow Jones Financials Index, many buy and hold investors presumed they would instead have gained 100%. Sorry, Charlie, the devil is in the details.
Take the case of the Vanguard Telecommunication Services ETF (nyse: VOX), whose stated goal is to track MSCI's U.S. Investable Market Telecommunications Services Index. After expenses, Vanguard's ETF underperformed its benchmark by 5.7 percentage points.
However, because of Securities and Exchange Commission diversification rules, the Vanguard ETF was forced to hold only 19.3% of its biggest holding,
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In other cases, ETF managers get in the way of hitting their own benchmarks. The iShares MSCI Emerging Markets ETF (amex: EEM) is "optimized" by its fund managers, in that it intentionally seeks a representative sampling instead of an exact duplicate of the index. Thus, instead of owning all 741 stocks in the underlying MSCI index, it owned 344 stocks last year and three country-based ETFs. Before expenses, this ETF had a tracking error of 407 basis points--four whole percentage points.
Vanguard's version of the ETF, Vanguard Emerging Markets ETF, had a tracking error of only 16 basis points. While iShares' version missed the mark, it also has eased some of the pain that emerging-markets investors have felt. In the last 12 months, the iShares ETF is down 53.5%, versus 55.9% for Vanguard's better behaving emerging-markets ETF.
The accompanying slide shows reveal the 20 best and worst performing exchange-traded funds in 2008 when it comes to tracking their benchmarks.
The worst offender on the list was iShares FTSE NAREIT Mortgage REIT, which missed its mark by almost 12 full percentage points. According to Greg Savage, a senior portfolio manager at iShares, his mortgage REIT ETF suffered from the same SEC diversification problems that Vanguard's Telecommunications ETF did.
Some of the underlying members of the troubled mortgage REIT index plummeted and were removed from the index by FTSE. At the same time, one of its holdings,
The bottom line for most investors is to monitor the performance of ETFs, versus their indexes; pay close attention to expense ratios and fees; and ultimately choose an ETF that is actually doing what it says it's going to do. Ironically, a whole new crop of so called "actively managed" ETFs is emerging, promising things like rotation into superior performing sectors. This should cause so called tracking errors to soar, making it harder for investors to tell the well-behaved ETFs from the malcontents.