ETF Update: Tracking Errors, Tax Returns, New WisdomTree ETF, Gold Highs, 3 Investing Tips, Active ETFs

Tracking Errors

ETFs are designed to follow indexes, but they can't always do it precisely. When they deviate, it's called a tracking error. This is the difference in performance between the index and the ETF itself, reports Jesse Emspak for Investor's Business Daily. ETFs that track less-liquid markets or securities tend to diverge from the underlying securities. Other times, tracking error strikes when a provider attempts to optimize rather than closely track an index. An example of this is ProShares Ultra Semiconductor (USD), which seeks a return of 200% on the daily movement of the Dow Jones U.S. Semiconductor Index.

Another major reason tracking errors occur is because many funds have maximum allocations to a single security, around 25%. Securities within a fund that make up 5% of assets can't add up to more than 50%. So these limits make it so that even if an index has a stock that makes up a large portion of it, the ETF can't mirror that and the provider has to adjust it. For example, The Dow Jones U.S. Telecommunications Fund (IYZ) follows an index that has 46% of its value in AT&T (T) and 22% in Verizon (VZ), but the ETF has 17% in AT&T and 14% in Verizon.

Also, tracking errors aren't always a negative thing. The iShares MSCI Mexico Index (EWW) outperformed the index because it had more weight in smaller-cap stocks than the index did. This is an example of when ETFs can be considered more diversified than the industries or markets that they represent.

Maximize Tax Returns

New research is displaying how index fund and ETF investors can maximize their after-tax returns. Some tax experts believe that mutual funds shareholders' tax bills will be the highest ever since 2000. In contrast, index funds and ETFs often have little or no taxable distributions. Eleanor Laise for The Wall Street Journal reports that investors holding these funds could slash their tax bill and boost their portfolios' performance by taking an "asset location" approach, which refers to how investments are divided between taxable and tax-deferred accounts.

Here's a tip on asset location: Keep tax-efficient investments such as index funds and ETFs in taxable accounts. If you must hold less tax-efficient holdings such as bond funds and commodities-based funds, put them in a tax-deferred account such as an individual retirement account or 401(k). While it's important to take advantage of tax-deferred accounts, it's also important to keep assets spread between taxable and tax-deferred accounts. You never know what tax rates will be 20 to 40 years from now. If you use more tax-efficient investments, such as ETFs, then there might be less to keep up with.

New WisdomTree ETF

WisdomTree announced today that it will launch a new small-cap dividend-weighted ETF today under the ticker symbol (DGS). DGS will trade on the NYSE Arca and will have an expense ratio of 0.63%.

The ETF is designed to track the WisdomTree Emerging Markets SmallCap Dividend Index and will be the first ETF to offer pure international exposure to primarily small-cap stocks selected from 19 emerging market nations, including countries in Europe, Asia and Latin America.

Gold Highs

Market Vectors Gold Miners (GDX) jumped to an all-time high this week as gold approached the key $800-an-ounce level on broad dollar weakness. The ETF hit a record high of $49.76 in intraday trading on Monday, reports Wanfeng Zhou for Thomson Financial. Currently, GDX is up 21.3% year-to-date. The U.S. Dollar Index, which tracks the greenback against the world's major currencies, fell to a record low in intraday trading today ahead of an anticipated interest-rate announcement by the Federal Reserve on Wednesday. Most economists expect the central bank to cut the federal funds rate by 25 basis points this week.

The top holdings in GDX include Barrick Gold (ABX) at 15.7%, Newmont Mining (NEM) at 10.7% and Goldcorp (GG) at 9.3%. Other gold ETFs have hit record highs as well, including:

• streetTracks Gold Shares Fund (GLD) - up 23.5%
• iShares Comex Gold Trust (IAU) - up 23.0%
• PowerShares DB Gold (DGL) - up 16.9% for the last three months, having launched in early 2007. It invests in gold futures not the bullion.

Investing Tips

When you invest in an ETF, you want to pay attention to the "bid-ask" spreads. These are the premiums that you pay every time you buy or sell. With time and some work it is possible to keep these spreads to a minimum, reports Ian Salisbury for The Wall Street Journal.

Remember, ETFs are structured like a mutual fund, yet trade on an exchange like a stock, so there are management fees like a traditional mutual fund, and there are brokerage commissions and spreads, like a single stock. These expenses don't make ETFs expensive, in fact, they are less expensive than traditional funds. Here are tips to keeping the spreads as small as possible:

• Gauge the spread.Widely-traded large-company ETFs tend to have thinner spreads than those more thinly-traded small-company stocks. For example, the SPDRs (SPY) has an average spread of one cent or 0.1%. On the flip side, Market Vectors Global Alternative Energy ETF (GEX) has an average spread of 21 cents or 0.5% of its share price.
• Use trading techniques.
  Investors can limit ETF spreads by placing a limit order. In this type of trade, investors offer to buy or sell shares at a set price, not at the only available price at the time of the trade. However, if not many people are willing to trade on those terms, the order might sit a long time.
• Avoid trading early
  Experienced traders know not to trade as soon as the market opens at 9:30 a.m. Eastern time. Market makers have a hard time pricing ETFs during the first few minutes of the trading day, so spreads can be wider for the first five to 10 minutes of the day.

Actively-Managed ETFs On the Horizon

The elusive goal of bringing an actively-managed ETF to market is still a futuristic ideal, but six managers believe they have the formula. Raquel Pichardo for Investment News says that Vanguard, and Bear Stearns have filed proposals for an actively-managed ETF.

Meanwhile, Firsthand Capital Management, Managed ETFs, AER Advisors, and XShares have filed for exemptive relief to offer these funds. Managers who want to offer these ETFs want to keep the benefits associated with passively managed ETFs while outperforming the market with active management.

However, the managers have faced many regulatory hurdles, the biggest one being transparency. Managers worry that full transparency of their trades will betray their investment processes and open the door for front-runners. For some managers, the answer to this problem is to have lag time between when a transaction is executed and when it is reported. Others think that they can manage daily reports; passive ETF managers report holdings daily.