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A look at tracking problems, credit problems and how the
industry will change.

In the midst of all of the market volatility, there have
been some very pronounced problems in the exchange traded funds business.  In addition to highly publicized issues
around the Lehman default on the Opta ETNs, the problems with the short
financial Rydex, ProShares and Deutsche Bank funds and the stopped trading and
near default of the AIG-backed ETFS ETCs, there’s been a whole lot of trouble
out there.

Less publicized, but possibly even more disturbing are the
completely unreported credit risks around ETFs lending out their underlying
shares to make handsome revenue (and then the ETF shares themselves being lent
out by brokers)…and we all know there is no free money. Who’s borrowing the
shares? They’re collateralized? With what? We need more transparency/assurance
here, particularly in this environment. I want to know that “You own the
underlying” really means “I own the underlying” with no credit risk thrown in,
thank you very much.

It’s been a good time to get a gauge of all the product
structure issues…a sort of trial by fire.

There have been rumblings about tracking error, so I thought
I would take a look at that.

Let’s just look at some of the big funds and funds we know
have had problems in the past or are in the news now.  I used all iShares because, well, their Web
site ROCKS.  (We’ll certainly do a big
revised tracking error study across all families soon) The iShares site is so
far beyond all the other ETF issuer sites that it’s almost laughable now, I
hate to say. Every distribution, holding, spreads and equivalent index return
right there.  Just a pleasure to work
with. We need to get our site where theirs is for ALL ETFs globally. We are
working on it. All they need to add on the iShares site is a line on share
lending revenue (good luck) or (maybe?) HOW the lent shares are being
collateralized in each fund (i.e. with what):

Anyway, here’s my sampling of tracking. This is as of 9/30,
so it’s missing some of the recent fun, but should give you a fair idea of
where iShares is at anyway:

iShares Tracking Error Year To Date

Source: Barclays Global Investors. Data as of 9/30/2008

If you were looking for problems, welcome to tracking error
nirvana, where (almost) all the tracking error is positive. I don’t know
whether to be dancing with joy or very, very nervous.  Mostly dancing for joy I’d say. That EEM fund
is just a tough beast to control with the optimization, liquidity and market
opening issues. I like the Vanguard structure for that one and in less liquid
areas on tracking error.  EEM was down
BIG last year on tracking error and is UP big this year.  DVY I know iShares has publicly said they for
all intents and purposes actively manage to optimize dividends.  You optimize enough though, and you’re
obviously playing with tracking error fire. And if it can be 200 basis points
positive, and can be 200 basis points negative more or less.

On all the rest, I guess we can attribute it to share
lending (50% of revenues from that go into the fund), managing cash flow and
index changes and, uh, maybe that cash is beating the crap out of about
everything else right now. So the more cash you have on hand, the more positive
tracking error you’ll have in many of the funds.  Not that iShares is doing that, but it can
certainly be a way to buff up returns when markets are moving the wrong way. It’s
why active often outperforms indexed in bear markets.

We’ve got plenty more to look at.  It’s blogging heaven right now.

Last 5 posts by Jim Wiandt

• FINRA Warns On Leveraged ETFs - June 19th, 2009
• What is Wrong With Matt Hougan? - June 16th, 2009
• ProShares, Direxion Are NOT ETFs - June 16th, 2009
• Shock And Awe - June 12th, 2009
• ETFs Are A Scam? - June 10th, 2009