(Dow Jones) Exchange-traded funds are designed to track the market's moves, but many were off the mark by a wide margin during the financial crisis.
Nearly all ETFs are index funds, meaning investors expect returns to closely mimic those of market gauges like the Standard & Poor's 500 or the Barclays Capital (formerly Lehman) U.S. Aggregate Bond Index. Even factoring in investment fees, popular index funds tied to the broad U.S. stock market often produce investment returns that miss benchmark returns by only a few hundredths of a percentage point each year.
The recent proliferation of ETFs targeting exotic investments such as emerging-market stocks and junk bonds makes such expectations seem quaint. In 2009, ETFs missed their targets by an average of 1.25 percentage points, a discrepancy more than twice as large as the 0.52-percentage-point average they posted in 2008, according to a study of ETF returns released this week by Morgan Stanley.
Some ETFs, which are mutual funds that trade on exchanges like stocks, own every stock or bond in their target index. Because that approach can increase investors' trading costs, however, most hold just a representative sample, opening the possibility for discrepancies, known as tracking error. Traditionally, tracking errors haven't been a huge concern for investors. But last year, 54 ETFs showed tracking errors of more than three percentage points, up from just four funds the prior year. And a handful of the 54 missed by more than 10 percentage points.
The results suggest that investors need to closely monitor how many stocks or bonds an ETF owns relative to its benchmark. Funds that own just a small fraction of those securities-sometimes just one-fifth of the stocks and even smaller fractions of the bonds-may have a hard time hitting annual targets. Funds with fewer holdings than otherwise identical competitors should have lower trading costs but may be less suited to long-term investors, for whom annual returns are a bigger concern.
While many ETFs that missed their marks last year are small or narrowly focused, that wasn't true across the board. The $40 billion iShares MSCI Emerging Markets Index ETF returned 71.8%, lagging the 78.5% return for its benchmark by 6.7 percentage points.
The $3.7 billion SPDR Barclays Capital High Yield Bond ETF posted a return of 50.5% versus 63.5% for the index it tracks, lagging by about 13 percentage points. And the $200 million Vanguard Telecom Services ETF returned 29.6%, overshooting its benchmark's 12.6% return by more than 17 percentage points.
To be sure, 2009 was an unusual year, where financial instruments of many stripes handed investors unwelcome surprises amid a devastating credit crisis. Moreover, many ETFs, especially those that target domestic stocks that are easy and cheap for portfolio managers to trade, remained on target. The SPDR, the largest ETF on the market, missed matching the return of the S&P 500 by just a 0.19 percentage point. Large-company stock funds from iShares and Vanguard were even more precise.
A larger tracking error hurts investors by making fund values unpredictable at any given time, but it doesn't necessarily mean returns will suffer significantly in the very long run. Funds that undershoot one year might overshoot the next.
While iShares MSCI Emerging Markets Index ETF fell well short of its mark last year, for instance, it outperformed in 2008. Since its inception in 2003, the fund has posted average annual returns of 23.19%, compared to 23.1% for its benchmark.