QQQ and SPY Tracking Error Analysis

QQQ and SPY Tracking Error Analysis

I think one of the largest areas for practical investigation in finance is reviewing dollar-weighted versus time weighted returns, especially for vehicles that are traded heavily.  I am going to try to analyze one major ETF per month to see what the level of slippage is due to trading.

But if my hypothesis is wrong, I’ll post on it anyway.  The last post I did on this was on SPDR S&P 500 ETF (NYSE:SPY), the S&P 500 Spider.  The slippage was 7%+/year.

Now I have done the calculation for the PowerShares QQQ Trust, Series 1 (NASDAQ:QQQ), the PowerShares QQQ Trust, which mimics the Nasdaq-100 (NASDAQ:NDX).  The Nasdaq 100 is more volatile than the S&P 500 (INDEXSP:.INX), so I expected the gap to be worse, but it wasn’t: from the inception in March 1999 to the end of the fiscal year in September of 2011, the dollar weighted return was 0.38%/year versus a time-weighted return that a buy-and-hold investor would get of 0.77%/year.  0.4% of difference isn’t much to talk about.  It still indicates a little bad trading.

That said, the net amount of unit creation and liquidation tended to be small.  Maybe that is the difference.  I have to think more about this, but my advice to anyone using exchange traded products remains the same — read your prospectus carefully, and understand the weaknesses of the vehicle.  If creation units don’t have to be something exact, ask what that might imply for your returns.

Anyway, here were the figures from my dollar-weighted return calculation:

I used annual data, and assumed midperiod dates for the cashflows.

The next ETF I plan to analyze is XLF, the Financial Sector Spider.  I suspect that will look bad, but who knows?
Full disclosure: short SPY in some hedged accounts.

By David Merkel, CFA of Aleph Blog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.