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Morningstar Publishes Research Report about Tracking Efficiency in Chinese Equity Exchange-Traded Funds

Morningstar Asia Limited, a subsidiary of independent investment research firm Morningstar, Inc. (NASDAQ: MORN), 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). The report is an extension of Morningstar’s February 2013 research paper about measuring tracking efficiency in European ETFs.

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. Morningstar analysts used two metrics to evaluate the tracking efficiency of these funds:

  • Tracking error: the measure of volatility of a fund’s return in relation to its benchmark; and
  • Tracking difference: the difference between a fund’s actual return and the benchmark’s return over a specific period of time, on an annualised basis.

“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,” Jackie Choy, ETF strategist for Morningstar Asia, said. “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.”

Key highlights of the research 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; and
  • Offshore Chinese equity ETFs have lower levels of tracking error and tracking difference compared with onshore Chinese equity ETFs.

“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,” Choy said. “Improved disclosure will further our ability to analyze these products and help investors vet these funds properly.”

The research report explores the tracking error, tracking difference, and estimated holding cost for both physical and synthetic replication ETFs by each of the five major indices: FTSE China 25, HSCEI, MSCI China, FTSE China A50, and CSI 300. 

In 2013, Morningstar published a “Guide to Investing in Chinese Equities via ETFs,” outlining the opportunities and risks investors face when accessing Chinese equities through ETFs. The guide is available online.

Morningstar has approximately 110 manager research analysts worldwide who provide research and ratings on approximately 4,300 funds and ETFs. The company provides data on approximately 160,200 open-end mutual funds, 10,700 exchange-traded funds, and 7,400 closed-end funds, as of March 31, 2014.