ETFs Deliver on Promise of Low Tracking Error

A recent Morgan Stanley report concluded that the weighted average tracking error for ETFs in 2008 was 39 basis points or 0.39%.

In the blogpost ETFs stuck close to indexes despite 2008′s volatility, MarketWatch’s John Spence summarizes the findings from the report that looked at how well ETFs stayed close to their tracking indexes.

One ETF that delivered very low tracking error was the Vanguard Total Bond Market ETF (BND). Although the fund holds only 3,731 of the 9,168 securities in the index, the tracking error was only 5 basis points or 0.05%.

Funds that delivered higher tracking errors were hampered by diversification requirements. For example, Spence points out that the Vanguard Telecom Services ETF (VOX) had a big negative tracking error because it was underweight in AT&T.

The large telecom returned 28% in 2008 compared to the fund’s overall return of 10.5%, however, SEC rules prevented VOX from fully matching the index’s 50% weighting of AT&T.

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