One of the challenges facing ETFs is tracking error. In other words, by design they track a particular index. In doing so we all know that indexes don’t have fees and ETFs do. Thus, right out of the box they should lag in performance relative to the index. This is also the reason for the lower cost structure for ETFs as apposed to the actively managed mutual fund. Most ETFs have tracking errors, but there are some that are larger than others. Understanding ther reason behind the error is an important decision point. The primary difference between funds is management fees. Vanguard ETFs have made a point of stating that difference and in reality made a living in the mutual fund arena on that point along. In the emerging market sectors one of the most popular selections is the iShare MSCI Emerging Markets Fund (AMEX: EEM). The tracking error of this fund is more than usual when looking at an ETF that tracks a specific index. One’s first reaction would be to think there is something wrong with the fund or the fees are too high. Yet when you dig into the rationale behind this you find it to be how the fund is designed more than what it charges in fees.

Looking under the hood of the fund you see the design by Barclay’s is not to completely replicate the index, but to have an optimization approach to building the fund. There are more than 840 securities in the index and EEM holds approximately 360 (as of 4/7/08). The difference is the optimization strategy that Barclay’s uses to replicate the index. Optimization brings in the human element of what should be included and what should be left out. This in turn creates tracking errors. Looking at the funds performance data over the trailing 12 months ending March 31, 2008, the index returned 21.33% while the fund returned 16.84% or a difference of 4.49%. Since inception of the fund in April 2003 the tracking error is 0.74%. The point here is not to take shots at Barclay’s, but to state that you as an investor should have a clear understanding of what you are invested in so you can manage your expectations of what you will get by investing your money.

EEM is one of the five largest ETFs by assets and it is important that you understand the fund if you are invested. Reading the funds description as published on their website you don’t find this clearly defined. It states that the fund seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of publicly traded securities in emerging markets, as represented by the MSCI Emerging Markets Index. Maybe it should state that through Barclay’s optimization discipline we seek to provide investment results that correspond generally to the index. I digress, the key to you as an investor is understand as clearly as possible what you own and why you own it. Tracking errors occur in every investment understanding and accepting it okay, your goal should be to understand. 

In previous pieces I have written, one of my challenges with “Alpha” driven ETFs is just this issue, underperformance relative to the index. Alpha in my perspective is controlled by you the investor based on the risk you are willing to take relative to the market. But that is a completely different story. In researching this further I found that Vanguard Emerging Markets ETF (AMEX: VWO) tracks the exact same index with a 12 month performance ending March 31, 2008 of 21.82% which was better than the tracking index (21.33%). This is not to say that Vanguard is better, but to show that their strategy is to own every stock in the index. Granted this does create some other issues, such as tax ramification, but tracking the index in this case produces better results. As investors taking the time to review options prior to putting your money to work is the prudent approach. Both of these ETFs have their merit based on the strategy they employ. Barclay’s shows over the life of the fund the difference is less than the last 12 months. The point is knowing why, if you are invested in their fund, you may be lagging the index currently.