Index Tracking Errors in ETFs

As exchange-traded funds proliferate, the problem of tracking error (failure of an ETF to mirror its index precisely) could become more noticeable. Last summer, a Morgan Stanley study found that nearly one in five U.S. ETFs had an annual tracking error of 1% or more, but that ratio could rise as new ETFs come out for narrower and more esoteric categories.

Currently, the iShares MSCI Brazil (EWZ) and iShares MSCI Hong Kong ETFs (EWH) are among the worst cases with correlations of only 95% and 94.5%, respectively, to their indexes (due to liquidity, regulatory constraints). The Vanguard Telecommunications Services (VOX) and iShares Dow Jones U.S. Telecom (IYZ) ETFs correlate to their indexes by 97.6% and 95.6%, respectively (narrow sector and SEC diversification rules).

ETFs are often recommended because they reportedly deliver market returns, better than the average mutual fund. But when tracking error is included, many ETFs could be just as guilty of underperforming the market.