Morningstar identifies factors influencing ETF tracking error

ETFs have generally done well in limiting tracking errror, according to new research published by Morningstar.

The data and research services provider has identified factors that influence tracking error and tracking difference in exchange traded funds, and applied its findings to a selection of 65 funds linked to eight equity indices.

Among the findings are:

   – ETFs using synthetic replication typically produce lower tracking error than those using physical replication. However, there is less of a direct relationship between tracking difference and a fund’s replication method.

    – TER is the most predictable and easily quantifiable factor affecting a fund’s performance relative to its benchmark. Nonetheless, it is not the only one and, in some cases, may not even be the most important.

   – Securities lending income, cash drag, tax optimisation, rebalancing costs for physical ETFs and swap fees for synthetic ETFs can also impact a fund’s relative performance.

Morningstar notes that other factors, such as product and index construction, counterparty risk and brokerage commissions also need to be considered beyond tracking error when investors evaluate ETF products.

Hortense Bioy, director of European passive fund research for Morningstar, said:
“Tracking error and tracking difference both play a part as complementary measures for assessing the replication quality of an ETF. As ETFs continue to gain in popularity, there is an increasing need for investors to be clear about these most commonly used metrics. In particular, there seems to be considerable confusion around tracking error, its meaning, key drivers, and calculation.”

“Beyond the definition provided last year by ESMA in its final guidelines on ETFs and other UCITS, we believe that investors would benefit from a harmonised approach to calculating tracking error. Our report intends to open up this discussion.”

To read the full report click here: [asset_library_tag 6311,Morningstar Report Measuring Tracking Efficiency]


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