Do ETFs stay on track?

Most exchange-traded funds (ETFs) are index trackers, meaning they aim to replicate the performance of a basket of stocks, bonds or other assets. One of the major reasons for their popularity is that the average active fund manager typically has trouble matching the index's performance, let alone beating it. Yet they charge you fees as if they do.

But that doesn't mean you can always assume an ETF will deliver the return of the index it's based on (even allowing for a small, expected underperformance by the fund to reflect its fees). The tracking performance of ETFs that notionally follow the same benchmark can be surprisingly different.

Take the multiple ETFs on offer that track the Euro STOXX 50, a popular benchmark of large blue-chip stocks, including BASF, Bayer, Siemens, Total and Unilever. You should expect the return gap between the top- and bottom-performing Euro STOXX 50 ETFs to be as much as 1% a year. Differences in fees explain only a small part of that divergence. So what about the rest?

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One explanation is tax on company dividends. European countries typically deduct up to 30% as a withholding tax from the dividends paid by local companies to non-residents. But the ETF may be able to receive dividend income from the stocks within the fund at a lower tax rate, generating what looks like an extra return versus the index. However, this is simply the result of the index provider taking too pessimistic a view on dividend tax before publishing its return.

The ability of a fund manager to lend out stocks, or generate extra income via the derivatives used in a synthetic' ETF, also affects index tracking. Conversely, the fund may be charged fees by its derivatives counterparties. You can't see them in the advertised total expense ratio (which isn't total at all), but these charges can cause extra underperformance. ETFs may also own only a selection of the shares in an index, rather than all of them, another cause of divergent returns between the fund and benchmark especially in less liquid markets.

The good news is that European regulator ESMA has just ruled that ETF providers must in future give investors their estimate of likely future tracking performance. Even so, before buying an ETF, study its past performance to get some idea of how closely it will track its benchmark.

Paul Amery edits www.indexuniverse.eu , the top source of news and analyses on Europe's ETF and index-fund market.