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Why you need to check the tracking performance of an ETF before investing

by , 22 September 2014

Exchange traded funds (ETFs) are passive funds with a listing on the stock market.

An ETF aims to track the performance of a particular index or commodity.

For instance, if the JSE's Top 40 Index rises by 10%, you'd expect a Top 40 Index ETF to also rise by around 10%.

Instead of opting to invest in a unit trust where the fund manager tries to beat the market for a fee, an ETF tracks a wide range of markets.

So what should you look at before investing?

Let's take a closer look…


You need to check how well an ETF tracks before investing

The whole idea of an ETF is to track the underlying index. If an ETF isn’t achieving this, there’s no point investing in it.

So the first thing you need to do is check the tracking performance. You need to compare the returns of the ETF compared with the returns of the index.

An index has running costs, which the index doesn’t, so the ETF won’t track the underlying 100%. This is called tracking error. So the better the match, the better.


What type of method does the ETF use to track the index?


It’s also worth checking how the ETF tracks the underlying index. There are three ways, Phil Oakley in Money Week explains:

Full replication
As the name suggests, this is when the ETF comprises all the shares in the index it tracks. This is the best approach, but only if it’s done in a cost effective way.

Partial replication or optimisation
This is when the fund manager buys a representative group of shares that are in the index. This can be a good method, but there may be more tracking error, which means your returns may be less.

Synthetic
This is when the fund manager enters an agreement with another party. This counterparty agrees to provide the return of the underlying index while the ETF provider owns collateral to protect investors against the counterparty going out of business.

But there are two main risks associated with synthetic ETFs.

The first is the counterparty may not match the performance of the index. The second is the counterparty goes bust. Yes, the ETF provider has collateral, so you wouldn’t lose all of your money, but it wouldn’t be the return of the index.

So there you have it, why you need to check the tracking performance of an ETF before investing.

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