Average tracking error increases for US listed ETFs

The average tracking error for US listed ETFs increased in 2009 to around 125 basis points (bps), according to Morgan Stanley.

A report by the firm's research team in North America reveals the most common sources of tracking error include fees and expenses, portfolio optimisation and index changes.

However, the report notes compliance with the Securities and Exchange Commission's diversification requirements can also cause "extreme tracking error" for certain ETFs, as these funds might be compelled into material weighting and holding deviations from their underlying benchmarks.

Tracking error is the difference in total return, between an ETF's net asset value and its underlying index, according to Morgan Stanley.

The report says ETFs that utilise the full replication method by buying the constituent securities in the index were still able to track their underlying indices closely, despite the market volatility last year.

Nonetheless, the bank found there was higher tracking error in 2009 compared with 2008. The percentage of ETFs with tracking error greater than 100 bps increased from 13.5% in 2008 to 37.5% in 2009. At the same time, the percentage of funds with tracking error of less than or equal to 25 bps fell from 44.6% to 22%.

The study also shows ETFs based on international indices experienced the largest absolute level of tracking error. Last year, the weighed average tracking error for international ETFs was 232bps, compared with 92bps in 2008. The firm largely attributes these deviations, especially in relation to funds tracking emerging market indices, to optimisation techniques.