The WSJ featured a story on the discrepancies between an ETF’s performance and the underlying index it is supposed to track:
True believers in index funds are eyeing a problem churned up during the market’s turbulent passage over the past two years—tracking error.
That is where a fund’s performance veers from the index it is supposed to track. This is a problem for index funds covering smaller slices of the market, whose member stocks are less liquid and sometimes more volatile than broad-market benchmarks.
Tracking error isn’t much of a problem for funds following the most-used broad-market index, the Standard & Poor’s 500-stock index.
In light of the tracking situation, investors should pay attention to the differences among the niche index portfolios. That is particularly true for buyers of exchange-traded funds, which unlike open-end stock funds, are predominantly index-linked.
Look at the markedly divergent results of two ETFs that track the same international-stock index—iShares MSCI Emerging Markets Index ETF (EEM) and Vanguard Emerging Markets ETF (VWO). Both follow the MSCI Emerging Markets Index. But the Vanguard ETF gained just over 76% last year, while the iShares offering was up nearly 72%. The index itself was up 78.5%. In 2008, though, the Vanguard ETF was down almost 53% while the iShares fund fell about 50%. Both beat the index, which was down 54%.
One factor here is cost. The Vanguard ETF charges much lower yearly fees than the iShares fund: 0.27% of assets compared to 0.72%. That savings is passed directly to the investor and boosts returns.
While I am aware of these discrepancies, they will have no bearing as to whether I take a position in either fund once the upward trend dictates that I do so. However, my point here is a different one.
A reader, who had seen this article as well, mentioned in passing that VWO, having lost 53% in 2008, certainly had made up its losses with a stellar performance of +76% in 2009.
That is not correct, and it’s an easy mistake to make.
Say, you invested $100k in VWO the beginning of 2008. With a loss of 53%, this reduced your portfolio value to $47k at the end of 2008. In 2009, this ETF gained 76% bringing your portfolio value back up to $82,720. That means, despite the great gains in 2009, you still need to make another 20.89% just to get back to break even.
Such is the enormous power of a bear market. You need to avoid it at all costs. Otherwise, you will be stuck trying to make up losses which, despite market cooperation, may take years to accomplish.
Disclosure: I have no positions in the ETFs discussed above.
Comments 3
Speaking of bear markets, I'm in more and more cash – getting stopped out! I wonder if this is it: the beginning of moving below the TTI as well.
Ulli,
Investing is just like buying anything else, buy quality and then realize that no investment is perfect all the time. Maybe this year an index fund lags the index and next year they may exceed it. No big deal in the long term. Trend timing is much more important than a small discrepancy between the underlying index and the index ETF or the index fund.
Linda,
Well said; I agree.
Ulli…