Morningstar Advisor - August/September 2011 - (Page 59)

Exhibit 1 Fund Performance Through Time: Over time, the persistent drag of a fund’s holding costs is what matters, and short-term tracking volatility adds uncertainty. 1.4 $ Index ETF Tracking Volatility 1.3 Estimated Holding Costs 1.2 1.1 1.0 06/10 07/10 08/10 09/10 10/10 11/10 12/10 01/11 02/11 03/11 04/11 05/11 06/11 of the market in the underlying securities (blue-chip global equities will incur minimal trading costs, while trading credit bonds or emerging-markets stocks is far more costly), and a portfolio manager’s scale and efficiency. Other funds use swap contracts to provide synthetic index exposure or currency overlays, which pay costly spreads to the issuing banks. On the positive side for shareholders, passive fund managers also generate share-lending and repurchase-agreement revenue on their fairly stable holdings. Trading costs, swap and derivative costs, and lending revenue persist from year to year, because they all depend on the policies and ability of the manager, as well as the nature of the index tracked. With this persistence in tracking ability, we should be able to look at index funds’ return histories to identify the best performers, just as we do for traditional active funds. Short-Term Deviations care far more about the quality of portfolio tracking on a day-to-day basis than they do about long-term differences. Short-term deviations from the index could result from cash inflows and outflows, leaving a portion of the portfolio uninvested for a day or two. Similar timing issues can occur with dividend reinvestment if payouts take time to reach the portfolio, and dividend withholdings can cause payout sizes to differ from those assumed in the index. Finally, many passive funds tracking unwieldy fixed-income or broad equity indexes choose to follow an “optimized” or “sampled” portfolio by investing in a subset of securities that closely resembles, but does not perfectly replicate, the index. These short-term tracking errors also matter for long-term investors, though we cannot say beforehand whether these deviations from the index will be positive or negative. There’s no way to know if the day that cash sits outside the market will be an up day or a down day, and daily return discrepancies have an average value that’s near zero. However, small, accumulated short-term deviations could add up over time to bigger differences in trailing returns, so the average size of these daily discrepancies allows us to estimate the accuracy of our long-term tracking-difference measurements. The Limits of “Tracking Error” Traders, hedgers, and portfolio managers using exchange-traded funds to provide liquidity all The oft-used but ill-defined term “tracking error” is applied to two measures that roughly capture these long-term return drags and short-term discrepancies. To measure the long-term drag on returns, analysts often measure the return difference between a fund and its index over periods of a year or more to estimate the long-term drag on returns. To approximate the short-term volatility of performance against the index, they take the standard deviation of differences between net asset value and index returns over shorter subperiods (such as daily or weekly). Unfortunately, neither of these common measures of tracking error shows much predictive power for future performance. Tracking differences can vacillate wildly depending on the dates chosen for the measurement period; estimates of tracking MorningstarAdvisor.com 59 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Contents
Contributors
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011