Why don't tracker funds track the market?

A key selling point for exchange-traded funds is that most active fund managers fail to beat their benchmarks. But you can't always depend on ETFs to deliver the market return either. Paul Amery finds out why not.

Most active managers fail to beat their benchmarks. This is a key selling point for exchange-traded funds (ETFs) if you can't beat the market, you may as well track it. But a recent study by Morgan Stanley shows you can't always depend on ETFs to deliver the market return either. In 2009, the average US ETF underperformed its index by 1.25% in 2009, from 0.52% in 2008. Management fees account for just 0.3% of this gap. So what's going on?

To be fair to ETFs, part of the divergence is down to a mathematical optical illusion. Fees are levied daily within ETFs. So the tracking difference will always seem larger in rising markets and smaller in falling ones. So 2009's huge rally accounts for some of the rise in tracking error. But it's also partly down to ETFs moving into more esoteric areas of the market.

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Paul Amery

Paul is a multi-award-winning journalist, currently an editor at New Money Review. He has contributed an array of money titles such as MoneyWeek, Financial Times, Financial News, The Times, Investment and Thomson Reuters. Paul is certified in investment management by CFA UK and he can speak more than five languages including English, French, Russian and Ukrainian. On MoneyWeek, Paul writes about funds such as ETFs and the stock market.