Exchange-traded funds (ETFs) have become popular investment instruments over the past decade, globally and in SA. Since the first ETF was listed on the JSE in 2000, the popularity of this financial product has expanded exponentially.

In December 2018, locally listed ETFs had a market capitalisation of R77.8bn, compared with R42bn in December 2012. The underperformance of active managers and low investment management costs have contributed to the growth in demand for passive investment products. ETFs have been a beneficiary of this trend as the expense ratios of ETFs tend to be substantially lower than those of more traditional index-tracking unit trust funds.

ETFs are pooled investment vehicles that trade on a stock exchange in the same manner as shares. These ETFs are structured to replicate the performance of an underlying domestic or international equity, sector-specific, or style-based benchmark index. ETFs therefore have the ability to provide retail investors with low-cost, passive investment exposure to different markets or sectors.

Although the aim of an ETF is to replicate the risk and return characteristics of its specified benchmark, there can be differences in the realised returns due to, among others, transaction costs, management fees and market frictions.

The extent of mismatched performance is often referred to as the “tracking error”. Investors prefer a low tracking error as it shows that the realised performance of the ETF is relatively close to its benchmark. For ETFs that track foreign indices, a number of additional factors can contribute to the tracking error. These include mismatched market trading times and exchange rate volatility, which can affect the tracking ability of the fund. The expectation is therefore that ETFs that track international equity indices will have a larger tracking error — these investors may need to tolerate an additional “sacrifice” when investing in such an ETF.

Since relatively few academic studies have examined the tracking efficiency of SA listed equity ETFs, I investigated the tracking accuracy of equity ETFs listed on the JSE. A distinction was made between ETFs tracking local indices and those that replicated international indices from 2002 to 2018. ETFs had to have a live track record of at least one year (52 consecutive weeks). The resulting sample included 24 ETFs tracking local equity indices and 15 mirroring international equity indices.

Using weekly data, the analysis indicated that on average both local and international ETFs’ tracking errors were significantly greater than zero. Moreover, observed correlations with benchmark performance were less than perfect. These results were expected, as there are known costs involved in the management of ETFs. However, the extent of the tracking errors observed exceeded the average total expense ratios.

The finding suggests that additional factors, such as market frictions, may have a significant impact on the tracking ability of SA ETFs. Moreover, factors such as transaction costs, fund flows, corporate activity among benchmark constituents, the treatment of dividends by the index and index composition changes could all impact the tracking ability of ETFs.

There were major differences in the realised tracking errors in the two ETF groups studied. Some ETFs were clearly better at tracking their benchmark than others. Given that not all ETFs have the same tracking ability, it is important for investors to consider and compare tracking errors when investing in ETFs.

One unexpected result was that although ETFs following international indices had large tracking errors on average, these were statistically no different from ETFs tracking local equity indices. Considering the additional challenges of different market trading times and exchange rate volatility, this was a surprising result that calls for further research. The implication for investors who use locally listed ETFs to obtain offshore exposure is that, statistically, they will not be worse off than those using local tracking ETFs.

ETFs are very useful products for retail investors. They give small investors the ability to obtain passive, diversified exposure to a variety of asset classes and geographic regions by only having a stock broking account. However, it is important for these investors to realise that ETFs are not perfect in their ability to track their benchmark indices. As such, investors should give careful consideration to tracking error information. They should also manage their expectations as the actual realised returns of ETFs may not mirror the ETFs’ intended benchmarks exactly.

• Steyn is an academic in the business management department at Stellenbosch University and a CFA charter holder.