Quizmaster, Doug Hutchinson, has come up with another great quiz for us regarding the factors that may cause the performance of an ETF to differ from the performance of an index.
Good luck!
Consider this scenario:
Your friend Martha purchased an Exchange Traded Fund (ETF) that is designed to track a major bond index. 1 year after purchasing this ETF, Martha looked up the 1 year return of this bond index and noted that the 1 year return of the index was exactly 5.00%.
Martha assumed this meant that the 1 year return on the ETF that she purchased would also be exactly 5.00% since the ETF is designed to track the index. Martha was surprised to learn that her return on the ETF was slightly different than 5%.
What are some potential reasons why the return on Martha's ETF did not match the return on the underlying index exactly? (For the purpose of this example assume Martha did not have any brokerage fees/trading costs associated with purchasing the ETF).
Answer:
Here are some reasons why the performance of an ETF may differ from the performance of an index:
- Expense ratio: if an ETF charges 5 basis points (0.05%) to track an index, then all else equal you'd expect the return of the ETF to lag the index by 5 basis points.
- Sampling: In some cases it is not practical for an ETF manager to hold every single position in an index. Some indexes may contain thousands of securities and some of those securities may be illiquid and/or infrequently traded. In these instances, the ETF manager may choose to hold a representative sample of securities in the index rather than hold every single position in the index. In these cases, it is certainly possible that the return of an ETF will not mirror the return of the index exactly since the ETF won't hold the exact same positions as the index.
- Securities Lending: large institutional fund managers (such as those who run an ETF) may sometimes lend securities they own to other market participants. Securities lending usually occurs so that these other market participants can take a short position in a stock. In order to sell a stock short, you must first borrow the stock from someone else. The lenders (ETF managers) will charge interest on borrowed stock thereby generating additional returns for the ETF investors. **Securities lending is the main reason why some ETFs may occasionally outperform the underlying index even after expense ratios are taken into consideration.
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This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
