Are ETFs More Risky Than You Think?

Unlike mutual funds, which are managed to try to get the best return, exchange-traded funds are meant to accurately reflect an entire index of stocks. Investors pick ETFs when they want to invest in a broader group of stocks, not on individual companies, and they generally count on ETFs to do as well -- or as poorly -- as the broader indexes on which they're based.

But it turns out that a growing number of ETFs are failing to do just that. In 2009, tracking error -- the difference between the performance of an ETF and its index -- widened significantly, according to a recent Morgan Stanley report. U.S.-listed ETFs saw an average tracking error of 1.25% in 2009, more than double the 0.52% in 2008. The biggest offenders? Sector and industry funds, global funds, commodity and fixed-income ETFs.

Straying from the Path

So why does it matter if your ETF doesn't do what it was created to do? Well, investors choose ETFs, instead of mutual funds or individual stocks, in order to diversify their holdings -- and because they believe a broader index might perform better than a managed fund. From that perspective, tracking error can equal higher risk. In other words, tracking error can be cool when an ETF outperforms its index, and less cool when it underperforms the index.

It's a serious enough issue that investment management firm MainStreet Advisors reviews its selected ETFs to make sure they reflect their indexes, says Spencer Klein, senior portfolio manager at the company. "As an investment advisor, if an ETF that we have selected isn't matching well enough the performance of the underlying benchmark, we may have a real problem and would probably replace the ETF," he says, adding that MainStreet Advisors switched two ETFs from its portfolio after reviewing all of its ETFs at the end of last year.

What can knock an ETF off course? For starters, fees and expenses. "An ETF's management fees are paid from the fund's returns. Generally speaking, the higher the fee, the larger the tracking error of the ETF," says Joe Jennings, investment director for investment adviser PNC Wealth Management.

Then there's the net value of the underlying assets; that is, the stocks in the index that the ETF is based on. When an investor buys an ETF that is trading at a higher price than what its index's assets are worth, for example, the fund may perform differently than the index. "Ideally, it is prudent to purchase an ETF when it is trading near or below [net asset value], and prudent to sell an ETF when it is trading near or above its NAV," Jennings says. In other words, sell high, buy low.

Building a Responsive ETF

Of course, the construction of an ETF also is a big factor. Two ETFs attempting to track the same index may perform differently because they own a different number of stocks and have weighed the individual stocks differently within the fund, and these same factors can lead to greater tracking error.

Also, from time to time, indexes change. Stocks are added and deleted, and the longer it takes ETFs to catch up with those changes, the more likely it is for those funds to perform differently.

Less diverse indexes, such as those that track a specific sector, as well as indexes with small stocks that trade at low volumes, also are more likely to show sizable tracking errors, Jennings says. Fixed-income ETFs, such as those that track bonds, also tend to track less accurately than funds that track stocks, in part because fewer bonds trade every day than stocks, Klein says. "Given a finite number of bonds trading on any given day, wide and varying spreads, and high degree of dealer to trader negotiating ability, a fixed income ETF can have a very challenging time keeping up with its bond index," he says.

Different time zones can also play a role in creating tracking error, especially for international and commodity-based ETFs, he adds. When the underlying investments trade during different market hours than U.S. securities, prices sometimes move while the U.S. market is closed, and that can create a disconnect because ETF trading can't respond to what's happening on the index.

Is Your ETF Off Course?

The big question is, how do you know when your ETF has gone astray? Every ETF calculates what's called the intraday indicative value of its underlying index, which essentially reflects its net asset value. Investors can compare an ETF's market price to that indicative value to see how well the ETF is tracking its benchmark, and can monitor that matchup over time using an online quote system like Google Finance.

Simply enter the symbol of your ETF with "IV" and Google Finance returns with a chart of the indicative value over the past five days. You can then add the regular ETF symbol to this chart and see at a glance how close the ETF is tracking its index. Most ETF sponsors, particularly the larger ones, provide information about the indicative value going back to the ETF's inception.

When you're investing in an ETF, research its composition and review how well its past performance matched up to its index to get an idea of what sort of performance deviation you can expect, Jennings advises.

As Alan Segars, investment management officer of The Provident Bank's Wealth Management Department, puts it: "Is there a certain threshold where investors should immediately sell their ETFs? Hardly. Rather, portfolio managers need to factor tracking error into a holistic investment process." After all, some tracking error is inevitable, but you want to be sure that your ETF's deviation matches your investment goals.

In some cases, the tracking error might be worth the benefits, Klein says. "You may just realize that the performance slippage to the market is a modest cost to pay for the benefits of low cost, diversified and liquid access to otherwise diffuclt to enter markets," he says.

Only you can make that call.