Exchange Traded Funds outperform their Benchmark

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Monday, September 1, 2014/Uche Ndimele, Funds & Valuation Expert 

Lotus Capital has rolled out the Lotus Halal Equity Exchange Traded Fund “LHE ETF”. The open-ended fund which is open for subscription between August 15th and September 11th is intended to track the performance of the NSE-Lotus Islamic Index (NSE-LII). Its aim is to afford investors the opportunity of obtaining market exposure to the securities of the constituent companies of the NSE-LII and to replicate the price and yield performance of the index.

According to available information, initial, investment in the fund requires that investors purchase 100,000,000 Units of the ETF at an indicative unit price equal to 1/200 of the value of the NSE-Lotus Islamic Index on the day preceding offer subscription. The indicative offer price of a unit of the ETF has been set at N14.07 based on the NSE LII value of 2,813.19 as at 25th July 2014. This brings to three, the ETFs that will be actively trading on the Nigerian Market. The other two are the Vetiva 30 ETF and the Newgold ETF.

While the Vetiva Griffin 30 ETF tracks the NSE 30 Index which consists of the 30 most capitalized stocks on the floor of the Nigerian Stock Exchange and the Newgold ETF tracks the price of gold in the global market, the Lotus Halal Equity ETF will track the NSE-Lotus Islamic Index which is an Index that “tracks the performance of 15 Shari’ah compliant equities that have met the eligibility requirements of a renowned Shari’ah Advisory Board”. 

According to the Punch publication of August 27th 2014, arrangements have been concluded for Stanbic IBTC Asset Management to float yet another ETF, the IBTC ETF 30 which, like the Vertiva Griffin 30 ETF, will track the NSE 30 Index. By the time the IBTC ETF 30 Debuts, Nigeria will be boasting of 4 ETFs in the market. Currently however, ETFs only account for 1.68% of the total NAV of all mutual funds according to the August 22nd data released by the SEC. One of the questions that prospective investors will be ruminating or regurgitating about in their mind is “how have the already listed ETFs performed?” This question is not being asked because past performance guarantees future or present performance, on the contrary, investment experts warn that past performance does not guarantee future performance but, it is being asked because often times the past points to the future. 

Judging from the price charts of the ETFs superimposed against their benchmarks, it does appear that the ETFs are doing what they have been asked to do, track the index and give them a run for their money.

 


Analysis of the 31 months from January 2012 to July 2014 reveals that the Newgold ETF beat its spot gold benchmark 15 months but was beaten in 16 months. Don’t play with Gold that is what it is, Gold. However, a look at the yearly performance shows that the ETF beat the benchmark in 2013 and has beaten it so far in 2014. Though the ETF made a loss in 2013, its loss was less than the loss that was made by gold, so it has beaten the benchmark in 2 out of 3 years.

 


The Vertiva Griffin 30 ETF debuted in March 2014 so it does not have much of performance history; however, analysis also shows that within its short history of existence it has beaten its bench mark in three of four months. That is a 75% by academic standards, but this is investment not academics because in investment performance analysis, it is alpha, beta and tracking error that count. 

Tracking error is the difference between the performance of an index and an ETF. It measures how closely a portfolio or fund follows the index it is benchmarked to and  helps to answer the question,— how well did or does a fund manager replicate the performance of a specific index. Statistically speaking, “tracking error” is the standard deviation of a fund’s excess returns, where excess return represents the absolute difference between the fund’s performance and that of its benchmark. Since standard deviation acts as a measure of risk in investment, tracking error represents a risk to investors since any disparity between the return of an ETF and that of a benchmark index represents potential underperformance.  It therefore follows that a lower tracking error is good for investors because it shows more consistency in the periodic deviations between the return of the fund and that of its benchmark. In the same way, higher tracking error should be a cause of concern.

My analysis reveals that the tracking error of New Gold ETF vis a vis its bench mark is 1.63, meaning that the standard deviation for excess average monthly returns for the New Gold ETF over the benchmark, (Gold),  for the past 31 months is 1.63.  This to me is small but it depends on who is looking at the number and what their risk tolerance is, among other factors. ETFs are traditionally passive investment vehicles but they may be actively managed as well. When they are viewed as passive investments, investors expect the ETF to mirror the performance of the benchmark it is meant to track in which case they expect a zero tracking error. Unfortunately, tracking error is hardly zero due largely to the size of the expense ratio of a fund. It is therefore necessary for investors to pay attention to expense ratio when deciding on funds to buy into.  Other factors that can cause a divergence between the performance of an ETF and those of its benchmarked index include transactions and rebalancing costs and sampling effects. These will be discussed in another article though. From the above humble analysis, it appears that the ETFs are here to stay, they are doing their job, tracking their index or benchmark and going head to head with them in terms of performance and often times beating them.  It will be good to see ETFs that will track the oil and gas sector, the banking sector, and even bond and commodity ETFs since it is not every one that can invest in such sectors directly. Again, a market as large as Nigeria Stock exchange is ripe for some financially engineered products that can deepen the market and add to its liquidity.

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