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Most Exchange Traded Funds (ETFs) track an index. An ETFs ability to track the index should be a point of emphasis for investors before allocating any cash to the fund.  If you buy a fund that is designed to track a certain index – you want to make sure it can actually do that.  In a perfect world, the ETF should return what the Index it tracks returns, minus the expenses of the fund.  As you will see, it’s far from a perfect world…

Elisabeth Kashner wrote an article recently titled, How Well Run Is Your ETF?  It dives deep into an ETFs ability to track their respective index and covers the topic in much more detail than we could here.  The article is linked above, please read it when you can.  We wanted to highlight one important theme – the underlying basket of securities.

An index consists of underlying securities: stocks, bonds, etc .  These securities impact all operations of an ETF.  Spread, liquidity, tracking, replication, slippage, you name it…it is affected.   An index that consists of large US listed stocks is one thing – an index of more exotic securities is another.

ETFs are set up to track their respective index through optimization or replication.  If the index consists of a small number of liquid holdings, the fund will most likely fully replicate the index.  A US Stock Index with 50 large cap US stocks  would most likely be fully replicated by the adviser to the ETF – that is, buy every stock in the index at it’s exact weight.  This should drastically reduce tracking error.

On the flip side, take an ETF designed to track an index of 800 emerging market stocks.  This ETF will most likely use optimization to track the index.  Meaning, they will own some of the actual stocks and then use derivatives or other securities that “should” mimic the remainder of the index.  Highly optimized funds typically have higher tracking differences.  Optimization is not necessarily bad, but  an understanding of what exposure is being optimized shouldn’t be overlooked.

The decision to replicate or optimize is dependent on the underlying securities of the index – a repetitive theme in ETF land.

As an adviser or an investor, an understanding of the underlying securities an ETF provides exposure to is important.  Before picking up shares of any fund, it’s good to know if a fund can actually do what it is set up to do.  Understanding the index and the underlying securities should be at the top of any ETF due diligence list.

Here is the link to Elisabeth’s article at  How Well Run is Your ETF?