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ETF managers show 'vast' differences replicating Europe, emerging markets

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The difference in quality between exchange-traded fund (ETF) managers tracking European and emerging market indices is vastly different, as the Continent’s index proves easier to replicate, research shows.

Analysis conducted by Koris International, an investment adviser, found European equity ETFs showed managers had close to zero tracking error and a low tracking difference.

The tracking difference calculates the drag resulting from all costs and can be interpreted as the difference from the index an investor would expect, on average, if invested for one year.

Koris’s analysis also showed little difference between managers’ performance, meaning investors would not be significantly affected by choosing one over another for European equity.

This differs drastically to research on emerging market indices, which showed managers displayed “very divergent tracking qualities”.

The spread in tracking differences between the largest seven MSCI Emerging Market ETF managers went as high as 30 basis points, compared with around 14bps for the MSCI Europe index.

It also discovered trading volumes for ETFs following MSCI Emerging Markets were too low to allow for institutional sized orders.

Managers are more divergent tracking emerging market stocks over European stocks due to the compilation of the ETF.

Institutions must decide whether to replicate the index directly by holding securities, have sample replication or track the index using swaps and futures.

Direct replication and the use of derivatives provide a more accurate tracking but are costly compared with sampling, which can incur a higher tracking error.

The emerging market index added complexity covering 27 countries, as well as a range of markets operating different currencies, and offer fewer derivatives.

Arnaud Lilas, head of ETFs at Lyxor Asset Management, said: “ETF managers need to decide on the number of components in the fund, and the quality of tracking. Different managers make different choices.”

He said in Europe, the market is significantly more efficient, has a greater use of derivative trading with managers more dividend focused, and securities lending, making tracking easier.

“It’s a difference in the complexity of the indices,” he said.

Koris’s research also highlighted the five largest European equity ETFs trade, on aggregate, more than $10m (€7.3m) a day.

“This means liquidity is there on the secondary market, even for institutional-size orders,” the report said.

It also noted that, even with roughly $3.3bn invested in MSCI Europe ETFs, only one fund had amassed more than $1bn in assets.

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