Exchange-Traded Funds (ETFs) provide investment advisors and their clients access to a broad array of global asset classes. But advisors and investors alike must be aware that the performance of ETFs can differ dramatically from the index that the ETF purports to track.

One should expect the return of a passively managed ETF to match the return of its underlying index, less the expense ratio for ETF. For example, an S&P 500 ETF that charges 10 basis points (.1%) could reasonably have been expected to return 15.9% last year, 10 basis points less than the S&P gained. But that’s not always the case.

In fact, the average tracking error – the difference between the returns of an ETF and its benchmark index – is on the rise. A recent Morgan Stanley study suggests that this increase is the result of the expansion of ETFs into more-exotic areas of investment. According to Morgan Stanley, the average ETF had a tracking error of 59 basis points last year, up from 52 basis points in 2011. In 2012, 14% of ETFs had tracking errors of more than 100 (1%) basis points, up from 10% the previous year.

One major factor in tracking errors is “optimizing.” When an ETF is launched, the manamger must decide whether replicate the related index exactly – buy every single security in the index. That isn’t always practical, especially regarding emerging market indexes, where transaction costs are high, and in fixed income, where some bond indexes include securities that rarely trade.

In those cases, the ETF manager usually picks an optimized portfolio of stocks that is expected to perform similarly, although not in perfect correlation, to the underlying index. Dislocation occurs when the chosen basket of securities perform differently from the index.

Some ETF managers try to overcome the ETFs expense ratio by lending securities held in the ETF to short sellers. Such lending can generate a profit of about 40 basis points (.4%), which can offset the ETFs expense ratio. For example, over the past three years, the $20 billion iShares Russell 2000 Index ETF (IWM) has had an annualized return of 12.23%, just 2 basis points lower than its underlying index, even though it charged 20 basis points. Presumably lending practices offset the ETFs expense ratio.

Not all ETF providers share all of the lending profits with the ETF investors. BlackRock Inc.’s iShares unit, returns only 65% of its securities lending profits to its funds. State Street Global Advisors and Vanguard, on the other hand, return 80% and 100% of securities lending profits, respectively, to their funds.

Learning information regarding ETFs’ use of optimization and securities lending can help ETF inventors make an informed choice when deciding which ETF to buy.

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