Can ETFs outperform their underlying benchmarks?

Exchange traded funds (ETFs) are designed to track their underlying index, not to outperform their index. Ultimately you would expect to see the performance returns of the index less the ongoing charges (TER/OCF).

However, some actually outperform their benchmarks even after charges. This is due to a number of factors which I will outline below. These tend to be ETFs that are tracking large-cap stocks in developed markets like the US or Europe.

There are many ETFs that, although they don’t outperform their index, have good performance returns versus the index being tracked even after fees.

One of these is the PowerShares Nasdaq 100 UCITS ETF which tracks US shares. This ETF has a high weighting in the US technology sector with a TER/OCF of 0.30 per cent. The ETF doesn’t outperform the index after fees but it does do well, which is purely down to the lower withholding tax treaty of 0.15 per cent versus the full 0.30 per cent amount. This ETF has generally cost an investor an average of 0.10 per cent in fees so far over each of the last five years.

Like active fund managers, ETF managers have the ability to boost performance returns via a number of ways. These can include:

  • Tax efficiency: Indices generally account for full withholding tax (WHT) on dividend receipts. But, for an ETF (domiciled in Ireland say) there is a WTH agreement in place – for an S&P 500 Index the WHT is 0.30 per cent on dividend receipts but the treaty between Ireland and the US means that this is reduced to 0.15 per cent enhancing the return of the ETF versus the index. For European equity ETFs there are different WTH taxes applied for different countries.
  • Stock lending: Some ETF providers (similar to both active and passive fund managers) lend the underlying shares to third parties which can generate additional revenue to enhance performance returns of the ETF. The shares are lent out and collateral is accepted in the form of cash or securities of the same value or greater than the loaned shares. The revenue received from stock lending is then added back into the ETF after the applicable administration costs are paid for overseeing the stock lending.
  • Optimisation: This is often used when an ETF is tracking an index with many underlying shares which may be difficult to trade, such as an illiquid share, and therefore expensive to trade. Generally, the ETF will still have the same percentage weights in the sectors in the index but fewer underlying shares. Although for a straightforward S&P 500 ETF these are fully replicated to the index (same underlying shares as the index) as the market is so liquid and easy to trade.
  • Index rebalancing: An index has a set rebalance date and ETFs and funds tracking that index are required to rebalance in order to match the Index. The prices of the underlying shares can move around with the trading from many different funds and ETF managers will decide on when they want to do their rebalancing of the ETFs so that they do not have to buy high and sell low. In practice, this tends to be around the same date as the rebalance so that there is no performance drag away from the index but there will be trading opportunities depending on the timing of the trades.
  • Dividend enhancements: Scrip dividends can be received in cash or shares. Shares can provide good opportunities to enhance returns in certain markets.

The next table shows a small selection of large and mid-cap European equity ETFs that have outperformed their respective indices after fees. The table shows outperformance in basis points.

Lynn Hutchinson is senior analyst at Charles Stanley