The Trouble With ETFs

As more esoteric funds proliferate, they're failing to live up to their promises.

Here we go again. Wall Street takes a good product, the exchange-traded fund, and in pursuit of profits creates multiple permutations. There are now nearly 450 ETFs, 75 of which were launched this year. In their rush to market, providers are creating flawed funds. Instead of mimicking the performance of an index, plenty are missing the mark, often falling short.

New research from Morgan Stanley (MS ) shows significant "tracking error" in a number of these funds. That's the difference between the ETF's return and that of the index it's supposed to replicate. It works like this: The total return for the Dow Jones Transportation Average was 9.81% last year, while the ETF that tracked it gained only 8.92%. After accounting for expenses the tracking error was 0.41 percentage points. In short, investors aren't getting all they expect.


Funds that track the big indexes like the Standard & Poor's 500 rarely go far astray, according to Morgan Stanley. That's because they own widely held stocks that are easy to trade. The misfires happen when ETFs try to match more esoteric indexes, like the High Growth Rate Dividend Achievers Index (DAH ). These niche indexes may have big stakes in fewer stocks or hold small companies that are harder to trade. "With all of the new and innovative indexes, there are questions whether these things can be faithfully replicated," says Dan Culloton, a senior analyst at Morningstar Inc. (MORN ).

Foreign ETFs often veer off the track, too. The iShares S&P Latin America 40 Index Fund (ILF ) missed its benchmark by 1.23 percentage points last year. That's because the fund can't always buy all the locally listed shares it needs in Mexico, Brazil, Argentina, and Chile. "There's an acceptable level of tracking error, depending on the particular market," says Christine Hudacko, a spokeswoman for Barclays Global Investors (BCS ), the largest ETF provider with $270 billion in 128 portfolios.

Sometimes regulatory barriers affect a fund's performance. Case in point: The iShares DJUS Telecommunications ETF failed to match its underlying index in 2006 by nearly four percentage points, an extraordinary divergence. The problem was that AT&T, which gained 53% last year, is 46% of the index but only 24% of the telecom ETF. (Securities regulations bar a fund from having more than one-quarter of its assets in a single company's stock.)

These errors don't always work against the investor. In some cases ETFs outperformed by a wide margin. PowerShares WilderHill Clean Energy beat its bogey by nearly three percentage points. Investors might be pleased, but that's not indexing. "The job of an ETF manager is to manage vs. the index," says Paul Mazzilli, director of exchange-traded fund research at Morgan Stanley. "The only source of error should be the fees."

The best way to avoid errant funds is to stick to the big, plain-vanilla offerings with low expenses. The major-market ETFs, and those based on "styles" such as large-cap growth stocks or small-cap value, usually run within several hundredths of a percentage point of their indexes. Fixed-income ETFs also come close to their targets, within 0.08 percentage points. Indexing is a game of inches, not miles. While you are never going to get exact duplication, the point of an ETF is to get within a whisker of the bull's-eye.

By Lauren Young

    Before it's here, it's on the Bloomberg Terminal.