Lyxor develops ETF efficiency indicator

Feb 28th, 2013 | By | Category: ETF and Index News

The success of exchange-traded funds (ETFs) has attracted a growing number of new providers to the market, offering investors a wealth of choice. Very often there are multiple providers offering ETFs on the same index. For example, the Euro Stoxx 50 Index is the underlying benchmark for more than 20 competing ETFs. This leaves investors faced with a difficult question: how to select the most efficient ETF.

Lyxor develops ETF efficiency indicator

Paris-based Lyxor has developed a new ETF efficiency indicator that could help investors compare ETFs. The indicator is based on performance difference, tracking error volatility and liquidity.

In theory, ETFs following the same index should all provide very similar investment returns as they are designed to closely replicate the indices that they track.

In practice, however, these returns can vary owing to, among other things, the method of index replication (synthetic versus physical), management fees, stock lending income and the bid/ask spread.

Fund selection is an important issue for investors and the topic has spawned an abundance of academic literature. However, such literature mostly concerns active fund selection and is not suitable for evaluating and comparing the performance of passive management and thereby ETFs.

In this context, Lyxor, one of Europe’s leading ETF providers, proposes a new performance measure, which it calls an ‘ETF Efficiency Indicator’. The indicator is based on three key parameters: performance difference, tracking error volatility and liquidity spread. The indicator is relatively easy to compute and, in conjunction with other qualitative factors, may help investors compare and evaluate ETFs.

The indicator represents the estimated one-year relative cost of an ETF versus its benchmark, which is calculated with a confidence level of 95%. The methodology behind it is based on a three-stage process. First, the annualised relative performance of the ETF versus the benchmark performance is calculated. Then the bid-offer spread that is displayed for that ETF on various exchanges is subtracted. Finally, a scaling factor is used to adjust this value in order to take into account the impact of the one-year tracking error volatility.

It’s important to note that the methodology is only applicable under normal market conditions. Abnormal trading situations may include sudden and sharp volatility or an increase or lack of liquidity in the underlying, in which the case the indicator may not efficiently reflect the relative cost of holding/trading an ETF.

This indicator offers investors a new way to evaluate ETF performance by helping to compare different funds that track the same benchmark, and could become a useful tool to assist decision-making for investors.

The rationale and construction of the indicator are detailed in an academic paper published by Thierry Roncalli, Head of Research & Development at Lyxor and Professor of Finance at the Evry University, and Marlene Hassine, ETF strategist at Lyxor.

The launch of Lyxor’s ETF efficiency indicator comes less than a month after Morningstar proposed a similar measure, the ‘Estimated Holding Cost’. Like Lyxor’s indicator, Morningstar’s Estimated Holding Cost measure considers how well an ETF is performing relative to is benchmark index after all expenses both disclosed and undisclosed have been accounted for. The measure captures the predictable drift from the total return version of the index due to both explicit and hidden costs and revenues, such as swap contract spreads, dividend withholding taxes, and securities lending.

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