ETF strategy: beware the overlooked risks of tracking error

Although counterparty risk has been at the fore of the debate surrounding exchange traded funds (ETFs), regulators have ‘overlooked’ a range of issues including tracking error that wealth managers should take into account.

According to Noël Amenc, director of the Edhec-Risk Institute, regulators focusing on the improvement of counterparty risk mitigation in ETFs, or the possible systemic risk implications of these products, are not paying enough attention to other performance issues.

‘By directing their thoughts and attention to the regulatory improvement of counterparty risk mitigation in ETFs, we believe regulators have overlooked a first-order issue, the comparability of performance among ETFs,’ he said. ‘

In particular, Amenc said it is crucial that key investors are given information on the total return generated through the risks assumed on their behalf by funds, such as the benefits from securities lending.

The institute also regards it ‘essential’ that indexing vehicles are required to disclose tracking error targets and results.

‘While index funds have grown on the back of passive management, there is no standardised measure or mandated disclosure of the quality of index replication at the European level,’
Amenc said. 

‘In the same spirit, we consider it is critical that regulators give a legal definition of what constitutes an index and decide on the transparency and auditability requirements of indexes, which after all remain the main drivers of the financial risks assumed by ETFs,’ he added.

Assess the risk

Wealth managers looking to buy an ETF must assess the underlying index, which provides the relative exposure to the respective market or asset class.

Traditionally, indexes are market cap weighted, but increasingly new types are coming to market, with different methodologies, such as fundamental indexing. There are also proprietary types of indexes being created, which can offer an enhanced methodology, drawing from an existing index.