Monday, February 22, 2010

ETFs Deteriorating

The average quality of ETFs has been deteriorating lately. Further evidence of this comes from a Morgan Stanley study where they found that U.S. ETF tracking error in 2009 averaged 1.25% compared to only 0.52% in 2008.

Not too long ago we could have summed up the low-cost indexing philosophy by saying “buy ETFs”. Those days are gone. The number of ETFs available has been exploding of late, but their quality is often questionable. Too often they have narrow focus and trade in more exotic investments where trading volume is low.

None of this means that there is a problem with low-cost indexing, though. The broadest and cheapest index ETFs are as good as they ever were. In some cases they have become even cheaper to own and they track their indexes even better. But the proliferation of poorer ETFs is sullying the “ETF” name.

The buyer beware rule is as true in the ETF space as anywhere else. Investors who only understand the low-cost indexing strategy at the level of “ETF = good” can get themselves into trouble.


  1. If nothing else, Wall Street is consistent in ruining a good idea.

  2. Thicken: From an investor point of view, "ruining" is the right word. From the Wall Street point of view, "exploiting" is more accurate.

  3. Michael
    Could there be other explanations, at least in part, of the tracking error in 2009 -- such as rather extreme volatility in markets that year?

  4. Larry: I think that the 2009 volatility is likely an additional explanation rather than an alternate explanation. You're right that the big jump from 0.52% to 1.25% is likely partly due to volatility. But it seems to be partially due to the introduction of inferior ETFs as well.