What Index Are You Tracking?

A closer look at some ETFs' underlying benchmarks reveals some important differences

Hortense Bioy, CFA 15.09.2011
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When shopping for an equity ETF, investors sometimes struggle to select the fund that best suits their needs, in part because of the ever-expanding number of options available and the many characteristics that distinguish what may seem to be otherwise identical products.

When comparing one fund to another, many investors often start by looking at the total expense ratio (TER)--the most apparent measure of the ongoing carrying cost of the investment. They then might examine other considerations like bid/ask spreads (a crucial measure of on-exchange liquidity and hence trading costs), the replication methodology (physical versus synthetic) and dividend treatment (distributing versus capitalising), amongst others. Investors should also compare like funds’ relative performance to determine those that most closely track the index they want to follow; and that’s when the selection process can become increasingly complicated.

Although some equity ETFs carry the same benchmark name, they might not be tracking exactly the same index in practice. Benchmark variants exist and they may offer slightly different returns to the benchmark’s most oft-quoted performance. One critical aspect of index construction and calculation is the matter of dividend reinvestment assumptions. An ETF can track a total return (TR) index, which assumes that all the dividends paid out by the index’s constituents are reinvested into the index. The fund will subsequently either distribute these dividends to fundholders, in the case of a distributing fund, or retain them, as in the case of a capitalising fund. Alternatively, an ETF can track a price return (PR) index, increased by the net dividends distributed by the constituents of the index. Instead of reinvesting the dividends into the index, the fund will retain them in a ‘cash bucket’ until they are distributed to fund holders.

It’s important for investors to understand which version of a given index a fund is tracking to understand how the treatment of dividends could potentially affect returns. Returns will inevitably differ depending on whether the fund assumes dividends are reinvested or held as cash before ultimately being distributed to shareholders.

A Few Real World Examples
To illustrate these different index calculation methods in practice, we have studied six Paris-listed CAC 40 ETFs and six London-listed FTSE 100 ETFs.

All the CAC 40 ETFs listed on Euronext Paris track the same total return index except Lyxor ETF CAC 40, which tracks the price return index plus dividends. Some investors--like insurance companies--favour this approach because it provides them with a fairly predictable stream of cash flow. Others, however, are turned off by the potential ‘cash-drag’ that could result from holding dividends in a separate cash account in upward trending markets. In practice this cuts both ways. While this approach could cause the fund to lag its counterparts if the benchmark is rising, it could also result in outperformance if the benchmark falls--as the cash drag becomes somewhat of a “flotation device”. During the 2008 market turmoil, Lyxor ETF CAC 40 beat the total return index by 5 bps, but subsequently underperformed by 114 bps during the 2009 market rally. The impact of un-invested cash on the fund’s performance will essentially depend on the difference between the interest rate earned on the cash and the performance of the total return index. Lyxor ETF CAC 40’s cash bucket, which represents about 3% of the fund’s net asset value, is currently earning the EONIA (Euro OverNight Index Average) rate.

It is worth mentioning that Lyxor ETF CAC 40 is the most widely-held fund tracking the French benchmark on Euronext Paris with currently over EUR 3 billion of assets under management. It is also the most liquid as measured by the three-month average daily trading volume.

Across the channel, there is no scarcity of options for investors seeking exposure to the UK large-cap equity market. Among the six FTSE 100 ETFs we have identified, only the Luxembourg-domiciled Lyxor ETF FTSE 100 tracks the price plus dividends return index, while the other five track the FTSE 100 total return index. iShares FTSE 100, which is the oldest ETF in Europe, remains the most popular and liquid fund tracking the UK benchmark with currently about £3.5 billion of assets under management.

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About Author

Hortense Bioy, CFA

Hortense Bioy, CFA  Hortense Bioy, CFA, is Director of passive fund research for Morningstar Europe.

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