RT Journal Article SR Electronic T1 ETFs JF ETFs and Indexing FD Institutional Investor Journals SP 54 OP 60 VO 2006 IS 1 A1 Vivian Lewis YR 2006 UL http://guides.pm-research.com/content/2006/1/54.abstract AB The ETF attractions include lower costs, easier access, increased liquidity, and fairness in pricing and trading. But some of their virtues may conflict with other features of the instrument, introducing tracking error. Buying or selling a basket of positions with one trade is always cheaper than buying them individually. But the key selling point for ETFs against other pooled investments like mutual funds has been their greater tax efficiency. The key to tax efficiency is trading less and incurring lower short-term capital gains, which are taxed prohibitively compared to long-term gains. ETFs' managers use portfolio optimization to cut costs, to place money in the largest and most liquid positions in the index they are tracking. This reduces trading in the smaller positions which can be more expensive, and which is more likely to have to be reversed because of index changes. The cost of adding or dropping a newcomer to an index is often excessive because index-trackers are all doing it. But portfolio optimization concentrating on the biggest issues to avoid marginal arrivals and departures from the benchmark index is the primary cause of slippage between an ETF and the index. The tracking error problem does not disappear just because there are mechanisms in place to resolve it. Tracking error arises most notably in the case of ETFs invested in foreign markets or regions which are closed when Wall Street is open, and visa versa. The booming markets for energy and raw materials have fueled a burgeoning demand for ways to invest in them. In addition to introducing a commodity rollover risk, the new ETFs often also are based on commodity markets which do not overlap Wall Street trading hours. So the tracking error problem from international ETFs is mirrored in commodity ETFs. Tracking error has serious consequences on the costs and proceeds of ETF trades which occur during the intervals when prices are out of phase. ETFs are often used as proxies for foreign market indexes in complex offsetting trades. There are costs for buying and selling the underlying securities to stabilize the price of an ETF. With a proliferation of small ETFs, those costs can interfere with the intervention. Meanwhile, arbitrage profits using the underlying securities in an ETF or one ETF against another can be made when ETFs are mis-priced. The recent proliferation of ETFs offering variations on the same theme increases risks. Costs of managing ever-smaller pools of money created essentially to cut the funds invested with your competitors ultimately costs investors money. The stabilization effect of the intervention of authorized participants will not be triggered if the ETF is too small for their intervention to pay off.