Much cheaper than peers
It’s very clear in the analysis below that the Vanguard Energy ETF is much cheaper than its peers. This has been Jack Bogle’s legacy and it will probably be a differentiating factor in the growth of assets under management for this ETF, as it tracks a very similar index as its peers—other than the iShares Dow Jones Energy ETF (IYE). In fact, the VDE ETF is almost as cheap as the S&P 500 ETF (SPY), which charges less than 10 bps.
Moreover, not only is the iShares Dow Jones Energy Index more expensive than its peers, but its price tracking error is much higher!
What is the price tracking error? A tracking error is the difference between the price behavior of a portfolio and the price behavior of its benchmark. With respect to ETFs, price tracking error is the difference in the most recent year one-year return between the ETF, and the target benchmark index is known as the “benchmark tracking error.”
- For a passive ETF, the tracking error should be low, ideally zero before fees, since the investor expects the ETF to return exactly what the index returns.
- For an active ETF, the tracking error should be a positive spread to show that the manager was able to generate value above the index returns.
Tracking error can vary depending on the complexity and liquidity of the underlying index. For ETFs tracking very liquid indices, it’s usually below 0.5%. In the case of MLPs, it can go beyond 4%. Other non-equity ETFs (like fixed income, real estate, or commodities) also tend to have relatively high tracking errors.
The Vanguard Energy ETF (VDE) performs well with respect to both the price tracking error and the NAV tracking error. What is NAV tracking error?
To start, the net asset value (or NAV) is the value of the underlying exposure of the ETF—the market value of the financial instruments (stocks, bonds) that the ETF owns. When demand for a given fund is very high or very low, the market cap of the fund may be above or below the NAV, meaning the fund is trading at a premium or discount to the market value of the fund’s investments. The premium-to-discount (the tracking error) is expressed as a percentage of the market value of the underlying financial instruments.
For closed-end funds, the premium-to-discount to the NAV can sometimes be quite sizeable, as opposed to open-ended funds, such as ETFs, which can create or redeem new shares (“units” in the case of ETFs) to acquire or sell market securities as demand varies deviates from that of the underlying instruments.
While the SPDR Energy Select ETF (XLE) is the nearest competitor to VDE with respect to the three metrics discussed in this article, the iShares Dow Jones Energy ETF (IYE) is the worst performer. The S&P Oil & Gas Exploration ETF has slightly higher fees and tracking error than XLE and VDE, but this is justifiable because it covers a smaller and more niche universe of securities.
In the next piece, we highlight ETF-specific risk for these securities.