An exchange traded fund (ETF) is a basket of securities which can be bought and sold on an intraday securities exchange, making it highly appealing to investors. Furthermore, ETFs are structured in such a way that in an ideal world, they would track a specific index such as the S&P 500, Nasdaq 100, Russell 1000 or MSCI without deviation; however, tracking errors do occur and investors should be aware of them.
Tracking errors in ETFs occur when there is difference between the aggregate market value of the holdings of the ETF and the traded share price of the ETF, which can cause an ETF to trade at a discount or a premium. One reason this deviation occurs is due to the internal expenses charged by ETFs and the costs that are associated during the creation/redemption process.
A second reason that ETFs can trade at a discount or premium to its net asset value, or NAV, is due to index optimization. Instead of fully replicating the holdings of an index that an ETF is replicating, in certain circumstances, ETFs use a strategy known as “optimization” to mimic an index as closely as possible when full replication of an index is not possible. Some reasons full replication can’t be achieved include limitations on position concentration, limitations on position size and/or there are a limited number of shares available on one or more index components.
A third reason that tracking errors can occur in ETFs is due to strict SEC diversification requirements that would limit holdings in such a way that the holdings in the ETF would deviate from those of an index.
Lastly, deviations can arise is if a fund stops issuing new shares. When this occurs, the price of an ETF can rise above what its true value is and trades at a premium.
While investing in ETFs generally offers diversification, low cost alternatives, transparency and the ability to access hard to reach markets, it is important to know what is under the hood of an ETF and to see how closely it tracks its respective index to ensure one is getting a great value.
Kevin Grewal is the founder, editor and publisher of ETF Tutor and serves as the editor at www.SmartStops.net, where he focuses on mitigating risk and implementing exit strategies to preserve equity. Additionally, he is the editor at The ETF Institute, which is the only independent organization providing financial professionals with certification, education, and training pertaining to exchange-traded funds (ETFs). Prior to this, Grewal was a quantitative analyst at a small hedge fund where he constructed portfoliosdealing with stock lending, exchange-traded funds, arbitrage mechanisms and alternative investments. He is an expert at dealing with ETFs and holds a bachelor’s degree from the University of California along with a MBA from the California State University, Fullerton. He is a contributing author on The Street – his articles can also be found published on various sites including Yahoo! Finance, The Globe and Mail , Daily Markets, MSN Money, Seeking Alpha, Fidelity Investments, Traders Library, and Minyanville.