[THE VIEW]Do ETFs Perfectly Track Their Indexes?

The Reality of Tracking Errors in International ETFs
Misconceptions, Structure, and the Limits Investors Should Know

In modern financial markets, exchange-traded funds (ETFs) have become one of the most powerful and popular investment tools for investors. When we purchase index-linked funds or ETFs, we often expect the returns of the product we bought to match exactly with the movements of the underlying index. In theory, if the index rises by 1%, our ETF account balance should also increase by 1%. However, the reality of the market is different from what the textbooks suggest. Especially when looking at the daily returns of ETFs that invest in overseas stocks, we frequently witness significant discrepancies between the index and the ETF price. Are ETFs truly tracking the index properly, or are they products with structural flaws?

To answer this question directly, most ETFs track the returns of their underlying indices extremely well. However, this process involves a much more sophisticated two-step mechanism than we might think. First, the portfolio manager manages cash flows and the fund's holdings to ensure that the fund's net asset value (NAV) closely follows the index. The next step is crucial: the roles played by market makers and arbitrageurs. Whenever the market price of the ETF diverges from its actual value, these players engage in arbitrage to bring the price back in line.

This mechanism works almost perfectly in U.S. equity ETFs. For example, if you look at QQQ, which tracks the Nasdaq-100 Index, or RSP, which uses an equal-weighted S&P 500 approach, the daily returns of the index and the ETF are nearly identical. This is because the underlying securities of the fund and the market where the ETF is traded open and close in the same time zone.

The confusion for investors mainly arises with international ETFs. For instance, if you look at the daily returns of ETFs like FXI, which holds Chinese stocks, there are often cases where the index rises but the ETF price falls. Many investors mistakenly believe this is due to problems with the ETF’s price discovery mechanism or a lack of competence on the part of the fund manager.

However, this is not an error but a natural phenomenon caused by a time lag. The issue of time lag is simpler than it seems. A China ETF listed in the United States closes at 4 p.m. New York time, but the Chinese stocks it holds have already finished trading hours earlier on the other side of the globe. Economic data releases or changes in global macro variables that occur while the U.S. market is open are immediately reflected in the price of the U.S.-listed ETF, but cannot be reflected in the spot index of the Chinese stock market, which is already closed. As a result, while the ETF price fluctuates in real time to reflect the movements of the 24-hour futures market, the index remains at its previous closing price, creating a temporary discrepancy.

The greatest advantages of ETFs are 'transparency' and 'accessibility.' ETFs allow investors to invest in the entire market with a small amount of money and, thanks to the presence of market makers, provide high liquidity that enables real-time trading like stocks. Getty Images

The important point is that these short-term tracking errors have little impact on long-term performance. When you remove daily volatility and compare long-term time series, such as annual returns, international ETFs also track the performance of their underlying indices very closely. Most of the price discrepancies that occur in the short term revert to the mean and are naturally resolved over time.

At this point, we need to reassess the fundamental strengths and weaknesses of ETF investing. The greatest advantages of ETFs are 'transparency' and 'accessibility.' It is virtually impossible for an individual investor to directly buy 50 Chinese companies or to adjust the weightings of 100 Nasdaq companies on a daily basis. ETFs allow investors to invest in the entire market with a small amount of money, and thanks to the presence of market makers, they provide high liquidity that enables real-time trading like stocks.

However, where there is light, there is also shadow. The disadvantages of ETF investing stem from this structural complexity. International ETFs, which are subject to time differences, or ETFs that include less liquid assets, may experience wider intraday price discrepancies. This can create unnecessary volatility risks for investors who trade in the short term. Moreover, not all ETFs enjoy the abundant liquidity of QQQ. When trading ETFs with low trading volumes, investors may incur hidden transaction costs due to the spread between bid and ask prices. In addition, in the case of leveraged or inverse ETFs that incorporate derivatives, it is important to note that holding them for the long term can result in a permanent divergence from the index's returns due to the effects of compounding.

Furthermore, some ETFs track indices developed in-house by the fund manager, rather than widely recognized public indices. In these cases, the transparency of the index calculation method or inclusion strategy may be lower, and the components may be changed more frequently. This is why it is important to thoroughly examine the index structure and management approach before investing.

Park Sungkyu, Professor at Willamette University, USA