12 Jul 2013, Marlène Hassine , Lyxor , Risk magazine
The growing popularity of exchange-traded funds (ETFs) and index-tracking funds, combined with the inadequacy of measures such as the information ratio, has led to an increasing demand for new fund-evaluation tools. Following the introduction of the European Securities and Markets Authority’s new guidelines on ETFs and other Ucits issues, more attention is being paid to how ETFs behave in practice and how well they meet the needs of investors.
The requirements being placed on issuers to give greater guidance on their funds’ expected tracking difference and tracking error have also created a need for a holistic measure to gauge the performance of ETFs.
Logic might suggest that all ETFs replicating the same market index are themselves the same. Yet you do not have to be an experienced ETF investor to know this is clearly a misconception. In practice, performance can vary. It is necessary to know which objective criteria to use when selecting an ETF. Until recently, there was no satisfactory scientific answer to this issue, but Lyxor’s research teams have changed that. ETFs have attracted growing numbers of providers to the market, leaving investors faced with a difficult question: how do they select the most efficient ETF? In response, Lyxor has developed an ‘ETF efficiency indicator’ – a comprehensive solution used to compare and evaluate all ETFs.
Traditional selection tools not suited to ETFs
Institutional investors, such as pension funds, insurance companies and balanced fund managers that rely heavily on ETFs, face a major challenge when choosing the best ETFs for their portfolios.
The analysis tools traditionally employed for active fund selection are not suited to selecting ETFs. In its simplest expression, active fund selection is based on one fundamental criterion: the information ratio. This indicator measures a fund’s return relative to its benchmark index, taking into account the relative risk taken compared with the index. However, using the information ratio to compare ETFs has a limitation that totally invalidates the analysis.
As a reminder, the information ratio is the ratio of outperformance (alpha) to tracking error volatility. In the case of ETFs, which replicate the index, the outperformance and tracking error figures are very low and the information ratios are therefore extremely sensitive, making traditional analysis irrelevant. Moreover, a product with a very low tracking error could easily be mistakenly ruled out on account of a weak information ratio, despite excellent index replication. Finally, a product underperforming very slightly and with a very low tracking error will be ruled out on account of its negative information ratio, whereas a product with marginal outperformance will be retained even with a high tracking error.
A new framework for measuring ETF efficiency
The ETF efficiency indicator combines tracking difference, tracking error and the key metric of secondary market liquidity in a single score. This gives investors a probabilistic, easy-to-understand assessment of the likelihood of future underperformance against the index. It also enables a straightforward comparison between funds based on the same index, meeting the increasingly sophisticated demands of investors and participants in Europe’s ETF market.
The efficiency indicator is a measure of ETF efficiency, combining the three performance characteristics that matter most to investors: performance (tracking difference versus the index), liquidity and tracking error. The efficiency indicator is a risk measure that consists of applying a value-at-risk (VaR) to these three parameters, which is defined as:
tracking difference – liquidity spread – scaling factor1 x tracking error volatility
The aim is to address three crucial issues for investors when selecting an ETF:
The ETF efficiency indicator was proposed earlier this year by Thierry Roncalli, head of research & development at Lyxor and professor of finance at the University of Évry, and Marlène Hassine, ETF strategist at Lyxor and member of the Société Française des Analystes Financiers (SFAF), in an academic publication entitled Measuring performance of exchange-traded funds.
ETF efficiency ranking
Lyxor has calculated the ETF efficiency measure for 50 ETFs tracking their respective benchmarks, using daily data over a one-year period (May 31, 2012–May 31, 2013).
The efficiency indicator in practice
Lyxor computes the ETF efficiency for ETFs tracking their respective benchmark indexes, using daily data over a one-year period (May 31, 2012–May 31, 2013). The components of the efficiency measure calculation are also shown and the best scores in the relevant categories are highlighted.
1 The scaling factor is the confidence level of the efficiency indicator. If the confidence level is 95%, then the scaling factor is 1.65
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