ETF Prime Archive

Be Aware Of ETF Tracking Errors

Exchange traded funds (ETFs) have become a very popular investment tool (Benefits Of ETFs) as investors have realized their numerous potential benefits over other types of investment vehicles.  However, it is equally important to understand that sometimes they suffer from what are referred to as tracking errors.

Tracking errors are the differences between the performance of an ETF and the underlying index that it tracks, and in general, the less tracking error, the better.  Here are four reasons tracking errors occur:

• Management Fees – In the ETF space, these are known as an ETF’s expense ratio and are taken directly out of net returns.  Naturally, the higher the expense ratio, the larger the tracking error.  Luckily, ETF expense ratios are generally lower than the expense ratios of mutual funds and are transparent to investors.
• Diversification Rules – The Securities and Exchange Commission (SEC) imposes strict diversification rules on ETFs, including one prohibiting an ETF from holding a single security comprising more than 25% of the ETF. For specialized or specific ETFs, at times, this can make it difficult for an ETF to track its index.
• Optimization Techniques – Some funds will buy only a subset of stocks that are in the underlying index in an attempt to provide performance similar to the index.  This technique is generally done to lower trading costs or to get around position limits.  The degree of optimization can affect the size of the tracking error.
• Dividend Drag – This occurs when there is cash in a fund.  Since no major index is constructed with a cash component, when a dividend is paid on shares inside an ETF, there is a lag between receiving and reinvesting the cash.  This error is generally very minimal, but it could potentially be a source of tracking error.

One way to get around tracking errors is through the use of ETNs (How To Use ETNs and ETFs), which are actually unsecured debt obligations of banks.  ETNs don’t have to worry about tracking errors because their returns are not based on the underlying securities, but instead, the ETN issuer guarantees the ETN holder a return that is an exact replica of the underlying index, less fees. 

Although ETNs get around the dilemma of tracking errors, they do come with an additional risk not found in ETFs; the credit risk of the debt issuer.  In and of itself, tracking errors are a disadvantage of ETFs; but at the end of the day, the advantages of these transparent investment tools far outweigh any disadvantage (Why To Use ETFs).

Massman Selected as Panelist for Inside ETFs Conference

Joe Massman, President & CEO of The ETF Store, has been selected as a panelist for the ETF 101 Workshop which kicks off the 3^rd Annual Inside ETFs Conference on January 10, 2010, in Boca Raton, Florida.  The Inside ETFs Conference is the industry’s largest event and the first and only ETF conference designed specifically for financial advisors.  The event is co-produced by Index Universe and Financial Advisor Magazine with sponsors such as iShares, Vanguard, StateStreet, Invesco Powershares, and Emerging Global Shares to name a few.  Over 500 are expected to attend with CNBC broadcasting live from the event.

As described on the conference website, “The Inside ETFs’ program is designed to bring financial advisors up to speed on all the latest developments in the ETF marketplace.  Over two-and-a-half days, our expertly chosen panels of investors, industry experts, academics and analysts will examine how ETFs can be used to create stronger risk-adjusted returns.”

Massman founded The ETF Store in 2008 to provide innovative investment solutions to individuals looking for alternatives to the commissions and high fees imbedded in the typical all-mutual fund portfolio.  Massman is also the founder of ETFBuzz.com, an online source for news and commentary about ETFs, and The ETF Institute, the first industry association for investment advisors utilizing ETFs in client portfolios.

China Gets a New ETF

As the popularity of emerging markets continues to grow (Emerging Market Choices), ETF provider Claymore Securities recently announced the launch of the newest member of its family, the Claymore China Technology ETF (CQQQ).

CQQQ is unique in that it gives investors the ability to gain direct exposure to technology, a sector expected to grow at an exponential rate in the coming years.   The new ETF seeks to track the AlphaShares China Technology Index, which measures the performance of publicly-traded companies based in mainland China, Hong Kong or Macau that are in the information technology sector.  The companies that are in the index must have an initial float-adjusted market capitalization of $200 million or greater and $150 million or greater for ongoing inclusion. 

Top fund holdings in this new ETF, which carries an expense ratio of 0.70%, include Tencent Holdings, Baidu.com and Nettease.com, and 78% of its assets are allocated to China while 28% are to Hong Kong (What to look for in an ETF).  What makes technology in this part of the world so attractive is that capital expenditures by the major players in the sector are expected to increase.

Of the emerging markets, Asia has drawn much attention due to its large growth and V-shaped recovery from the global recession.  More specifically, Hong Kong and China have been drawing the most attention (Why India is worth a look as well).  As for Hong Kong, the nation has seen GDP growth of more than 3% and has felt a domino effect from China’s growth and popularity.  Government stimulus plans, increases in domestic consumption, and favorable trade agreements are several reasons this region continues to grow quickly.

Some other ways to access China and Hong Kong are through the following:

• the Claymore China All-Cap ETF (YAO), which carries an expense ratio of 0.70% and primarily focuses on large cap companies
• the Claymore China Smal-Cap (HAO), which carries an expense ratio of 0.70% and focuses on small cap stocks
• the iShares MSCI Hong Kong Index (EWH), which carries an expense ratio of 0.52% and gives direct exposure to Hong Kong
• the Dow Jones Emerging Markets Composite Titan Index (EEG), which carries an expense ratio of 0.75%, allocates 24% of its index to China and enables one to reap the benefits of other emerging markets as well

Direxion Expands Exposure to Emerging Markets

At a time when emerging markets continue to draw assets and attention, Direxion Funds, an ETF provider known for its offering of leveraged and inverse products, announced the addition of four new ETFs providing investors with a way to implement similar strategies when investing in China and Latin America.

The new ETFs are leveraged bull and bear indexes which seek to replicate 300% of the daily performance, or 300% of the inverse daily performance, of the BNY China Select ADR Index and the S&P Latin America 40 Index.

The first of the ETFs is the Direxion Daily China Bull 3X Shrs (CZM), which aims to gain 300% of the daily performance of the BNY China Select ADR Index.  The BNY China Select ADR Index tracks select Depository Receipts of China-based companies which are traded on U.S. exchanges.  The second ETF is the Direxion Daily Latin America 3X Bull Shrs (LBJ) which aims to gain 300% of the daily performance of the S&P Latin America 40 Index, which measures the performance of large-cap companies from Latin America.  Similar to their domestic offerings, Direxion also will launch bear funds for both indexes, which will aim to give 300% of the inverse daily performance of those indexes.

In leveraged long ETFs offered by Direxion, roughly 80% of the asset value is invested in an “optimized” basket of securities as a proxy for the tracked index and represents a corresponding fraction of the ETF’s total return.  Remaining capital is invested in very short-term bond instruments which are used to collateralize derivative positions (over-the-counter total return swaps) which provide the remaining roughly 220% exposure for a 3x leveraged long ETF.  Direxion’s leveraged inverse ETFs gain exposure entirely through swap agreements, with the fund’s capital fully deployed in very short-term bond holdings which generate income and serve as collateral for swaps positions.  Swap providers typically gain exposure by way of futures and options positions.

While not for most individual investors, leveraged and inverse ETFs make up 5-7% of all ETF assets.  An important thing to remember is that these ETFs need to be monitored on a daily basis.  The goal of the funds is to return the daily return of an index, so the implications of compounding can have a dramatic impact on investor returns over longer time horizons.

Playing A Falling Dollar With Other Currencies

As the U.S. dollar continues to show signs of weakness and the U.S. economy struggles to overcome the powerful forces of high unemployment, investors have been looking at ways to hedge their exposure to the dollar and the answer might lie in other currencies.

Traditionally speaking, investors have shunned away from currencies due to their volatility and have turned to other areas like bonds, commodities and foreign markets to hedge their exposure to the dollar.  When it comes to commodities, most turn to gold (Ways to Play Gold) and crude oil to protect themselves since they are traded in dollars making them cheaper and more attractive to foreign investors.  As for foreign markets, most have turned to emerging and frontier markets (More on emerging markets) as these nations are growing at exponential rates and are putting their footprint on the global economy.

The U.S. dollar has fallen as a result of heavy borrowing and massive  “money printing” by the federal government in an attempt to fund programs to bolster the crippled economy and many think that it will continue to do so, keeping the dollar at depressed levels.  To capitalize on this situation through the use of foreign currencies, one can consider exchange traded products offered by Rydex Funds, WisdomTree and Invesco PowerShares.

The funds provided by Rydex are structured as grantor trusts with expense ratios of 0.4% and hold foreign currencies in overseas interest-bearing accounts where their appreciation or depreciation is directly determined by the movement in the relative currency versus the U.S. dollar.  They are primarily used to gain single county currency exposure.  Common Rydex funds include the CurrencyShares Australian Dollar Trust (FXA) and the CurrencyShares Euro Trust (FXE).

For a more diversified approach, Wisdom Tree offers the WisdomTree Dreyfus Emerging Currency Fund (CEW) which enables one to gain exposure to eleven different emerging market currencies, including India, South Africa, China, Brazil, Mexico, South Korea, Chile, Poland, Israel, Turkey and Taiwan.  The fund carries an expense ratio of 0.55% and aims to offer investors current income reflective of foreign money market rates available to U.S. investors.

PowerShares offers a unique approach to gaining exposure to foreign currencies through its PowerShares DB G10 Currency Harvest Fund (DBV) which takes long positions in futures contracts in the three G10 currencies with the highest interest rates while simultaneously taking short positions in futures contracts in the three G10 currencies with the lowest interest rates.  DBV carries an expense ratio of 0.75%

The above mentioned ETFs are just a few of the many currency ETFs available to investors.