The demand from consultants and clients for zero tracking error drives him to a sub-optimal solution.
The average tracking error of ETFs is 59 basis points, well under 1%, Morgan Stanley found.
Investors should take the time to explore the tracking error of the funds they own or are thinking about purchasing.
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In order to achieve zero tracking error, the fund manager must hold exactly the index for every second of the day.
The resulting curves for 30-year returns on a lump sum showed a chance investors could come out ahead assuming tracking error at the 5% level.
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Zero tracking error trumps total return as the performance standard.
These two scenarios can create an environment where performance expectations of investors may not be met due to the tracking error versus the underlying commodity index that is created.
But against that possibility investors should balance the fact that they stand a better than 50% chance of having 20-30% more money even at the highest level of tracking error.
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However, as index-based mutual funds and ETFs continue to gain popularity and active managers are increasingly pressured to control their performance tracking error relative to benchmark indexes, the markets could become less efficient.
In addition to tax efficiencies, ETNs aren't subject to tracking error an issue for ETFs since the issuer doesn't need to buy and sell assets to keep the notes' return in line with the benchmark index.
The expectation that an index fund will get EXACTLY the return of the target index sets the stage for an interesting problem: Zero tracking error is achievable, but it comes at a very high price.
Although some active managers may experience more short-term volatility and higher tracking error with their benchmarks, this growing trend should lead investors to look to active managers with long-term track records of strong risk-adjusted performance, as I foresee on-going attractive equity returns in the years ahead.
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