Tracking errors are much higher on US active ETFs than their European counterparts, analysis by Broadridge Financial Solutions has found.

That reflects a marked divergence between the two markets with Europe showing a clear preference for exchange-traded funds with lower fees and less active management.

In a report “Tracking error is a feature, not a bug”, it said the difference between a fund’s return and its benchmark index is a good way to measure the level of active management in an ETF. 

Broadridge said the US has a greater number of active ETFs using fundamental and highly active investment strategies, whereas Europe is more focused on systematic active ETFs that are rules-based and more closely resemble their index benchmarks. This is borne out in their pricing.

“In Europe, active ETFs have the highest proportion of funds with prices between 20 [0.2%] and 40 [0.4%] basis points, whereas in the US, active ETFs see the preponderance of products priced in the 70-90 basis points range,” Broadridge said. 

For example, in the US large blend category, US-based active ETFs have an average tracking error of 3%, 2% above Europe. Fees on the US products are seven basis points higher on asset-weighted average, it found. 

Looking at the 20 largest Morningstar categories by assets, Broadridge said: “There are a large number of equity and alternative strategies ETFs with annualised tracking error above 5%. As we look at pricing for these products, averages range form 40 to 80 basis points.” 

By contrast, in Europe the tracking error is lower, ranging from 0.5% to 3.5% and pricing is also lower, between 25 and 40 basis points. 

Our view

David Batchelor, senior analyst at QuotedData, said: “The conclusion from Broadridge that the higher the tracking error for an active ETF, the higher the fee, feels intuitively correct – so it is good to see it borne out by this report’s data. Even more compelling is the clear conclusion that European active ETFs are in general less active than their American peers. Again, this is in line with our experience, with the European landscape dominated by “systematic” active funds that aim for a small amount of outperformance of a benchmark (with a lower tracking error) versus the less constrained “fundamental” vehicles that dominate in America (with a higher tracking error). This is particularly the case at the larger end of the European market.

“There is likely not one sole reason for this difference, although one explanation seems to stand out: tax. ETFs’ in-kind redemptions limit capital gains and, while this has little tax advantage in Europe, in the US it limits or eliminates capital gains tax for investors while holding the fund. Therefore, an American active ETF with high tracking error will already be differentiated from a similar mutual fund (and is a reason few mutual funds are now launched Stateside), whereas in Europe it will not be, and indeed risks cannibalising a fund house’s assets – and therefore a less active vehicle will, perhaps counterintuitively, offer more differentiation.”

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