Morningstar shines light on tracking efficiency of Chinese equity ETFs

May 29th, 2014 | By | Category: Equities

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Morningstar Asia has published a new research report, ‘On the Right Track: Measuring Tracking Efficiency in Chinese Equity ETFs’, which examines the factors that influence the tracking efficiency of Chinese equity exchange-traded funds (ETFs).

Morningstar shines light on tracking efficiency of Chinese equity ETFs

Jackie Choy, ETF strategist for Morningstar Asia.

Authored by Morningstar’s global passive strategies research team, the report examines 33 ETFs listed in markets around the world that track the five major Chinese equity indices: FTSE China 25, HSCEI, MSCI China, FTSE China A50, and CSI 300.

The report explores the tracking error, tracking difference, and estimated holding cost for both physical and synthetic replication ETFs.

Tracking error is the measure of volatility of a fund’s return in relation to its benchmark. Tracking difference is the difference between a fund’s actual return and the benchmark’s return over a specific period of time, on an annualised basis. Estimated holding cost is the various explicit (e.g. expense ratio) and implicit (e.g. turnover, cash drag, spread/cost of derivatives, etc.) costs of holding an ETF.

Key highlights of the report include:

  • Chinese equity ETFs and emerging market equity ETFs show similar levels of tracking error and tracking difference but are inferior to their developed-market counterparts;
  • Physical replication Chinese equity ETFs, which are ETFs that buy and sell the constituents of the benchmark index, adhere to their benchmarks with similar levels of tracking efficiency compared with physical replication ETFs that follow emerging market indices;
  • Synthetic replication Chinese equity ETFs, which are ETFs that use derivatives to deliver a similar return as the index, tend to have inferior tracking performance relative to synthetic replication ETFs that follow emerging markets indices;
  • Synthetic replication Chinese equity ETFs offer superior tracking error, but greater levels of tracking difference, compared with physical replication Chinese equity ETFs;
  • Offshore Chinese equity ETFs have lower levels of tracking error and tracking difference compared with onshore Chinese equity ETFs.

Commenting on the report, Jackie Choy, ETF strategist for Morningstar Asia, said: “In general, we found that both Chinese equity and emerging market equity ETFs demonstrate similar levels of tracking efficiency, albeit at inferior levels than their developed market counterparts. Our study shows that ETF providers need to continue improving the transparency and accuracy of disclosures around performance, so that investors can have the research and information they need to make more informed decisions. Better disclosure will help investors compare and evaluate ETFs through common tracking measures, such as those we’ve proposed in our report.”

He added: “We’ve also observed that tracking error and tracking difference data points are extremely sensitive to minor changes in their inputs. As a result, investors should use accurate data in the calculations and exercise caution when interpreting the results. Improved disclosure will further our ability to analyze these products and help investors vet these funds properly.”

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