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Exchange traded fund performance

What Is Exchange Traded Fund Performance?

Exchange traded fund (ETF) performance refers to the returns generated by an ETF over a specified period, reflecting how well the fund has achieved its investment objective. ETFs are a type of investment fund that trades on stock exchanges throughout the day, similar to individual stocks. They belong to the broader financial category of investment vehicles. The performance of an ETF is primarily driven by the underlying assets it holds, such as stocks, bonds, or commodities, and how accurately it tracks its benchmark index.63, 64, 65

History and Origin

Exchange traded funds emerged as a significant financial innovation in the late 1980s and early 1990s, with the first U.S. ETF, the SPDR S&P 500 ETF Trust (SPY), launched in 1993.60, 61, 62 This offering aimed to provide investors with a low-cost, tax-efficient way to gain exposure to the S&P 500 Index.59 Since then, the ETF market has experienced substantial growth and diversification, encompassing various asset classes, sectors, and investment strategies.56, 57, 58 This evolution reflects a broader shift towards passive investing and a demand for transparent and cost-effective investment vehicles.54, 55 Global exchange-traded funds received a record $1.22 trillion in inflows in 2021, bringing total global assets invested in ETFs close to $9.5 trillion, according to Reuters citing Refinitiv Lipper data.53

Key Takeaways

  • ETF performance measures the total return of an exchange traded fund over a specific period.
  • The primary goal of many ETFs is to track a specific benchmark index, making tracking difference and tracking error crucial metrics.
  • Factors influencing ETF performance include expense ratios, trading costs, and the liquidity of underlying assets.
  • Investors can assess ETF performance by comparing it to its benchmark, peer funds, and overall market conditions.
  • While ETFs offer diversification and cost efficiency, they are subject to market risks and potential deviations from their stated objectives.

Formula and Calculation

While there isn't a single universal "formula" for overall exchange traded fund performance, the core concept revolves around the total return, which accounts for both price appreciation and any distributions. For an index-tracking ETF, a key metric for evaluating its performance relative to its objective is the tracking difference.

The tracking difference is calculated as:

Tracking Difference=ETF Total Return−Benchmark Index Total Return\text{Tracking Difference} = \text{ETF Total Return} - \text{Benchmark Index Total Return}

A negative tracking difference indicates that the ETF lagged its benchmark, while a positive tracking difference means it outperformed. Factors such as the fund's expense ratio, transaction costs from rebalancing, and securities lending revenue can influence this difference.51, 52

Interpreting Exchange Traded Fund Performance

Interpreting exchange traded fund performance requires understanding its objective. Most ETFs are designed to replicate the performance of a specific market index.48, 49, 50 Therefore, evaluating an ETF's performance often involves comparing its returns to those of its stated benchmark. A consistent tracking difference close to the ETF's expense ratio typically indicates efficient management.46, 47 Investors should also consider the time horizon over which performance is measured, as short-term fluctuations may not reflect the long-term effectiveness of the ETF in tracking its index. Furthermore, understanding the ETF's asset allocation and the market capitalization of its holdings can provide context for its performance.

Hypothetical Example

Consider an investor, Sarah, who is interested in gaining exposure to the broader U.S. equity market. She decides to invest in a hypothetical ETF, "DiversiFund S&P 500 ETF," which aims to track the S&P 500 Index.

  • Initial Investment: Sarah invests $10,000 in DiversiFund S&P 500 ETF.
  • Performance Period: One year.
  • DiversiFund S&P 500 ETF Performance: Over the year, DiversiFund S&P 500 ETF's share price increases by 10%, and it pays out dividends totaling 2% of the initial investment. Its total return is 12%.
  • S&P 500 Index Performance: During the same period, the S&P 500 Index has a total return of 12.1%.
  • Calculation of Tracking Difference: Tracking Difference=12%−12.1%=−0.1%\text{Tracking Difference} = 12\% - 12.1\% = -0.1\%

In this scenario, the DiversiFund S&P 500 ETF had a tracking difference of -0.1%, meaning it lagged its benchmark by a small margin. This minimal difference suggests the ETF was effective in replicating the index's performance, especially if its expense ratio was around 0.1%. Sarah's investment would have grown to $11,200 (excluding any trading commissions). This example illustrates how closely the ETF's performance mirrors its benchmark.

Practical Applications

Exchange traded fund performance is a critical consideration for investors and financial professionals in several practical applications:

  • Portfolio Construction: ETFs are frequently used to build diversified portfolios efficiently. Evaluating their performance helps investors select funds that align with their investment objectives and risk tolerance. For example, a bond ETF's performance is crucial for investors seeking fixed-income exposure.43, 44, 45
  • Strategic Asset Allocation: Financial advisors use ETFs for tactical asset allocation and sector rotation, leveraging their ability to provide efficient access to various asset classes.42
  • Performance Benchmarking: ETFs tracking specific indices serve as benchmarks for evaluating other investment strategies or actively managed funds.
  • Risk Management: Analyzing the historical performance of an ETF, especially its tracking error, helps investors understand the consistency with which it has mirrored its underlying index and identify potential liquidity risk.40, 41 The U.S. Securities and Exchange Commission (SEC) provides guidance and alerts on the risks associated with certain types of ETFs, such as leveraged and inverse ETFs.37, 38, 39
  • ESG Investing: The performance of ESG (Environmental, Social, and Governance) ETFs is increasingly scrutinized by investors seeking to align their portfolios with sustainability goals. The credibility of ESG ratings, such as those from MSCI, are used by the majority of ESG ETFs.36

Limitations and Criticisms

While exchange traded funds offer numerous benefits, their performance can be subject to certain limitations and criticisms:

  • Tracking Error: Despite their objective to mirror an index, ETFs can experience tracking error, which is the deviation between the ETF's returns and its benchmark's returns. This can be caused by various factors, including fees, transaction costs, cash drag, and fair value pricing adjustments.34, 35
  • Liquidity Mismatch: In certain market conditions, especially for ETFs holding illiquid underlying assets like some bonds, there can be a liquidity mismatch between the ETF shares trading on an exchange and the underlying securities. This can lead to discrepancies between the ETF's market price and its net asset value (NAV).33
  • Complex Products: Some specialized ETFs, such as leveraged ETFs and inverse ETFs, are designed to achieve their stated performance objectives on a daily basis. The performance of these ETFs over periods longer than one day can differ significantly from their stated daily objectives and may expose investors to significant losses, as warned by the SEC and FINRA.31, 32
  • Market Price vs. NAV: Unlike mutual funds, ETF shares trade on exchanges throughout the day at market prices, which may not always be identical to their NAV.30 While arbitrage mechanisms generally keep the market price close to the NAV, deviations can occur, particularly in volatile markets.29
  • Commissions: Although ETFs typically have low expense ratios, investors pay brokerage commissions to buy and sell ETF shares, which can be a significant drawback for frequent traders or those investing small, regular sums.27, 28

Exchange Traded Fund Performance vs. Mutual Fund Performance

Exchange traded fund performance and mutual fund performance share the common goal of generating returns for investors, but they differ fundamentally in their structure and trading mechanisms.

FeatureExchange Traded Fund (ETF) PerformanceMutual Fund Performance
TradingTraded on stock exchanges throughout the day, like stocks.25, 26Traded once a day at the end of the trading day, based on NAV.23, 24
PricingMarket price fluctuates throughout the day; may differ from NAV.21, 22Valued at NAV at the end of the trading day.20
TransparencyMost disclose holdings daily.18, 19Typically report holdings monthly or quarterly.17
FeesGenerally have lower expense ratios.15, 16Can have higher expense ratios, sometimes with sales loads.
Tax EfficiencyOften more tax-efficient due to in-kind creation/redemption.13, 14May distribute more capital gains to shareholders.12
Management StylePredominantly passively managed, tracking an index.10, 11Can be actively managed or passively managed.

The primary difference impacting daily performance observation is that an ETF's performance can be tracked in real-time based on its market price, whereas a mutual fund's performance is only updated once a day after the market closes.9 This intraday liquidity is a key differentiator for ETFs.

FAQs

How is Exchange Traded Fund performance measured?

Exchange traded fund performance is typically measured by its total return, which includes both price appreciation and any dividends or distributions paid out. It is often compared against the total return of its underlying benchmark index to assess how well it tracks its objective.8

What causes an ETF to deviate from its benchmark?

An ETF can deviate from its benchmark due to factors such as its expense ratio, trading costs incurred when buying and selling underlying securities, cash holdings that don't earn index returns, and corporate actions or rebalancing within the index that the ETF must mimic. This deviation is often quantified as tracking difference.6, 7

Can an ETF outperform its benchmark?

While most index-tracking ETFs aim to replicate their benchmark's performance, it is possible for an ETF to slightly outperform its benchmark due to factors like securities lending revenue, which can add a small amount of additional return beyond the index.5 However, typically, due to fees and trading costs, an ETF will slightly underperform its benchmark.3, 4

Are all ETFs passively managed?

No, while a large number of ETFs are passively managed and aim to track a specific index, there are also actively managed ETFs. Actively managed ETFs involve a fund manager making investment decisions to try and outperform a benchmark or achieve a specific investment objective, rather than simply replicating an index.1, 2

How do I check the performance of a specific ETF?

You can check the performance of a specific ETF through various financial news websites, brokerage platforms, or the ETF provider's official website. These sources typically provide historical performance data, including total returns, expense ratios, and often the tracking difference relative to its benchmark.