iShares ETF Tracking Error: Risks and Explanations

by: Index Universe October 10, 2008 | about stocks: AGG / CFT / DVY / EEM / EFA / EMB / FXI / GSG / IVV / IWM / IYY / SHY    
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By Jim Wiandt

A look at tracking problems, credit problems and how the industry will change.

In the midst of all of the market volatility, there have been some very pronounced problems in the exchange-traded funds business. In addition to highly publicized issues around the Lehman default on the Opta ETNs, the problems with the short financial Rydex, ProShares and Deutsche Bank funds and the stopped trading and near default of the AIG-backed ETFs and ETCs, there's been a whole lot of trouble out there.

Less publicized, but possibly even more disturbing, are the completely unreported credit risks around ETFs lending out their underlying shares to make handsome revenue (and then the ETF shares themselves being lent out by brokers)... and we all know there is no free money. Who's borrowing the shares? They're collateralized? With what? We need more transparency/assurance here, particularly in this environment. I want to know that "You own the underlying" really means "I own the underlying" with no credit risk thrown in, thank you very much.

It's been a good time to get a gauge of all the product structure issues... a sort of trial by fire.

There have been rumblings about tracking error, so I thought I would take a look at that.

Let's just look at some of the big funds and funds we know have had problems in the past or are in the news now. I used all iShares because, well, their website rocks. (We'll certainly do a big revised tracking error study across all families soon.) The iShares site is so far beyond all the other ETF issuer sites that it's almost laughable now, I hate to say. Every distribution, holding, spreads and equivalent index return is right there. Just a pleasure to work with. We need to get our site where theirs is for all ETFs globally. We are working on it. All they need to add on the iShares site is a line on share lending revenue (good luck) or (maybe?) how the lent shares are being collateralized in each fund (i.e., with what).

Anyway, here's my sampling of tracking. This is as of 9/30, so it's missing some of the recent fun, but should give you a fair idea of where iShares is at anyway:

iShares Tracking Error Year-To-Date

Ticker

Fund/Index

ETF Return

Index Return

ER

Tracking Error

Assets

IYY

Dow Jones U.S. Total

-18.99

-18.82

.20

+.03

$0.45 billion

IVV

S&P 500

-19.28

-19.29

.09

+.10

$14.2 billion

IWM

Russell 2000

-10.36

-10.38

.24

+.26

$11.5 billion

DVY

DJ Dividend

-14.52

-12.55

.40

-1.57

$4.2 billion

EFA

MSCI EAFE

-29.18

-29.26

.34

+.42

$27.7 billion

EEM    

MSCI Emerging Markets

-32.28

-35.54

.74

+4.00

$16.2 billion

FXI

FTSE Xinhua

-41.49

-40.81

.74

+.06

$4.9 billion

GSG

S&P GSCI Commodities

0.75

0.96

.75

+.54

$0.62 billion

AGG

Lehman Aggregate

0.64

0.63

.20

+.21

$9.4 billion

SHY

Lehman 1-3 Treasuries

3.82

3.82

.15

+.15

$8.8 billion

EMB

JP Morgan EM Bonds

-6.36

-5.89

.60

+.13

$0.10 billion

CFT

Lehman Credit

-6.69

-6.83

.60

+.74

$0.09 billion

Source: Barclays Global Investors. Data as of 9/30/2008

If you were looking for problems, welcome to tracking error nirvana, where (almost) all the tracking error is positive. I don't know whether to be dancing with joy or very, very nervous. Mostly dancing for joy I'd say. That EEM fund is just a tough beast to control with the optimization, liquidity and market opening issues. I like the Vanguard structure for that one and in less liquid areas on tracking error. EEM was down big last year on tracking error and is up big this year. DVY, I know iShares has publicly said they, for all intents and purposes, actively manage to optimize dividends. You optimize enough though, and you're obviously playing with tracking error fire. And if it can be 200 basis points positive, it can be 200 basis points negative, more or less.

On all the rest, I guess we can attribute it to share lending (50% of revenues from that go into the fund), managing cash flow and index changes and, uh, maybe that cash is beating the crap out of about everything else right now. So the more cash you have on hand, the more positive tracking error you'll have in many of the funds. Not that iShares is doing that, but it can certainly be a way to buff up returns when markets are moving the wrong way. It's why active often outperforms indexed in bear markets.

We've got plenty more to look at. It's blogging heaven right now.

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This article has 6 comments:

  •  
    Oct 10 01:18 PM
    You can call it anything but such 'error' is hedging. I don't buy an index to have the 'consolidator' hedge for me. That is for the same reason I don't buy foreign securities or the same indirectly from the consolidator if they hedge currency.
    Reply | Link to Comment
  •  
    Oct 10 01:30 PM
    iShares has a good web site; Powershares has a better one, IMO.

    As far as credit risk goes, I've been more cautious about iShares recently because Barclay's is on the edge of insolvency, with asset-to-equity leverage of about 60:1, last time I looked. Scary stuff.

    I wouldn't count on tracking error to provide returns. Better to pick a winning index, right?
    Reply | Link to Comment
  •  
    Oct 10 04:20 PM
    Why the heck are all the ETF trading at 5%+ discounts to asset value? I'm in BWX and called State Street and they couldn't really explain it. They said there are "market makers" that arbitrage for a living but offered no explanation. Can a "market maker" explain why the spreads are so high?! Is there counterparty risk involved?

    Look at these spreads!
    www.etfconnect.com/sel...
    Reply | Link to Comment
  •  
    Oct 11 12:49 AM
    The discount could be due to the early closing of ETFs. If the market rallies in the last 15(?) minutes, there will be a discount. Powershares says that somewhere on the site.
    Reply | Link to Comment
  •  
    Oct 11 05:02 PM
    Jim W.. timely article, looking at the data on AGG up through 9/30 I'd conclude, ok, not bad.. then AGG totally blew up on Friday Oct 10. Any ideas why? I stopped out on a sizable holding. No more iShats for me, they may have a nice website but I think Barclays stole my hard earned money.
    Reply | Link to Comment
  •  
    Oct 23 12:59 PM
    On AGG, you are obviously right, that one Friday, AGG traded 8 PERCENT off it's NAV- FOR THE DAY. And the High Yield iShare was off a cool 28% for the day. Whoa. But it's not actually really the ETF blowing up, as much as it is the BOND MARKET blowing up. On that day I would put a LOT of money on the ETF serving as a price discovery mechanism over the indicative NAV of the underlying index, which was stale and inaccurate. That's my take. We ran a lot of blogs and articles on this in the last week or two on indexuniverse.com
    Reply | Link to Comment
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