An Easy Oversight

The WSJ featured a story on the discrepancies between an ETF’s performance and the underlying index it is supposed to track:

True believers in index funds are eyeing a problem churned up during the market’s turbulent passage over the past two years—tracking error.

That is where a fund’s performance veers from the index it is supposed to track. This is a problem for index funds covering smaller slices of the market, whose member stocks are less liquid and sometimes more volatile than broad-market benchmarks.

Tracking error isn’t much of a problem for funds following the most-used broad-market index, the Standard & Poor’s 500-stock index.

In light of the tracking situation, investors should pay attention to the differences among the niche index portfolios. That is particularly true for buyers of exchange-traded funds, which unlike open-end stock funds, are predominantly index-linked.

Look at the markedly divergent results of two ETFs that track the same international-stock index—iShares MSCI Emerging Markets Index ETF (EEM) and Vanguard Emerging Markets ETF (VWO). Both follow the MSCI Emerging Markets Index. But the Vanguard ETF gained just over 76% last year, while the iShares offering was up nearly 72%. The index itself was up 78.5%. In 2008, though, the Vanguard ETF was down almost 53% while the iShares fund fell about 50%. Both beat the index, which was down 54%.

One factor here is cost. The Vanguard ETF charges much lower yearly fees than the iShares fund: 0.27% of assets compared to 0.72%. That savings is passed directly to the investor and boosts returns.

While I am aware of these discrepancies, they will have no bearing as to whether I take a position in either fund once the upward trend dictates that I do so. However, my point here is a different one.

A reader, who had seen this article as well, mentioned in passing that VWO, having lost 53% in 2008, certainly had made up its losses with a stellar performance of +76% in 2009.

That is not correct, and it’s an easy mistake to make.

Say, you invested $100k in VWO the beginning of 2008. With a loss of 53%, this reduced your portfolio value to $47k at the end of 2008. In 2009, this ETF gained 76% bringing your portfolio value back up to $82,720. That means, despite the great gains in 2009, you still need to make another 20.89% just to get back to break even.

Such is the enormous power of a bear market. You need to avoid it at all costs. Otherwise, you will be stuck trying to make up losses which, despite market cooperation, may take years to accomplish.

Disclosure: I have no positions in the ETFs discussed above.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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