Updated with correction.
If recent regulatory filings are any indication, large exchange-traded fund transactions are increasingly commonplace among North America's largest pension funds and endowments. Yet, for any holding period, returns can be significantly influenced by factors beyond the index return and the expense ratio.
Some of these factors are realized by the investor's trading desk, namely understanding the premium/discount trend of the fund's price vs. its net asset value, the market trading spread and liquidity. Then, portfolio management decisions and trading costs also significantly affect the tracking difference of the NAV to the benchmark, (and ultimately the market price), as well as the sheer challenge of trading a complex index.
A pair of first-quarter portfolio shifts by the New Jersey Pension Fund, Trenton, can help highlight many of these factors. In the first quarter, New Jersey reduced its holding in iShares MSCI Emerging Markets Index ETF, or EEM, by $100 million while increasing its holdings in iShares Core MSCI Emerging Markets Index ETF, or IEMG, by $33 million.
The first fund, one of the largest U.S.-listed ETFs, has a higher expense ratio, but tighter trading spread and is cheaper for market makers to create and redeem shares in bulk. The second fund was designed with a lower expense ratio, to challenge Vanguard's FTSE Emerging Markets ETF, but trades at a slightly wider spread and costs more to create than EEM. But, according to data compiled by research firm ETF.com, IEMG takes advantage of a larger, optimized portfolio including small- and midcaps to effectively overcome the fund's own expense ratio.
Since inception, the median rolling 12-month tracking difference for IEMG to NAV has been zero. For EEM, the tracking difference was just eight basis points better than the expense ratio. So, even while reducing its overall exposure to emerging markets, New Jersey is actually shifting into a cheaper, more efficient fund.
“There's skill in managing an index at a trading-desk level,” said Dave Nadig, chief investment officer for San Francisco-based ETF.com, which details the “efficiency” and “tradability” of every U.S.-listed ETF. The data are most helpful when evaluating equity portfolios, according to Mr. Nadig.
“Many newer ETFs don't hold all the index constituents. They tend to leave off less-liquid securities,” Mr. Nadig said, adding that “if the portfolio manager chooses wisely, the fund can outperform; poor choices bring underperformance.”
Another key differentiator of fund return is income from securities lending. Here large, complete portfolios and small, niche funds actually have something in common: Both are compelled to own small and midsize companies with floats just barely enough to hit an index, as well as large momentum stocks attractive to short sellers.
These hard-to-borrow securities, or “specials,” offer lower rebates on invested collateral, earning more income for the lender. While securities lending income and revenue share is disclosed by every ETF, determining the effectiveness of the lending program itself is discoverable only by a deep and consistent reading of lending income over several quarters.
For example, according to ETF.com data, ETFs with the greatest ability to outperform the expense ratio recently include niche funds focusing on hot-button investment categories such as Russia, alternative energy, biotech and dividends.
“The divergence between the expense ratio and the tracking difference is often noticed by those using ETFs as a cash management tool within an index strategy,” said Chris Hempstead, head of sales for KCG Holdings Inc. in Jersey City, N.J. “I suspect that many other institutions using ETFs are not as aware that smart portfolio management can overcome the expense ratio.”
Yet, according to ETF.com data, ETFs tracking more complex indexes — including the much-promoted “smart-beta products — tend to underperform their expense ratio due to trading costs and the difficulty of managing to an index built on factors or fundamentals for underlying weights and exposures.
For example, the median tracking difference for the Guggenheim S&P 500 Equal Weight Fund is 56 basis points, 16 basis points worse than its expense ratio. The PowerShares Buyback Achievers oversteps its expense ratio by 29 basis points.
”With a claim of "smart' often comes more frequent trading and trickier portfolios,” Mr. Nadig said.
“Because an index does not reflect trading costs, frequent portfolio turnover or less-intuitive reconstitutions will always negatively impact tracking difference,” said Aniket Ullal, founder of Fremont, Calif.-based First Bridge Data, which sells ETF datasets. “But, while tracking difference is a very important issue, the actual choice of ETF based on the index is still more important in determining investor returns.” n