- 2000: Volume 9, No. 5 Ask Dr. Index: Notes From the Field

Man, making house calls is TOUGH work.

As the good doctor's been on the road in the past few weeks, he's fielded a number of challenging questions on indexes and exchange traded funds (ETFs). Culled from the vast compendium of queries—thanks, Mom, for asking so many—are these gems:

Dr. Index -

Discussions of index-based investing often include talk of "tracking error." But when I compare the performance of my fund with that of its benchmark index, my numbers don't jibe with the analysts'. Do these guys use some sort of different math?

At the risk of sounding Clintonesque, define "different." Your confusion might stem from the assumption that tracking error is the arithmetic difference in annual returns, i.e., fund return minus index return. But it's not. Tracking error is a statistical metric that attempts to predict how two portfolios are expected to deviate from one another over a period of time. For example, a two percent tracking error represents about 2/3 odds that the performance differential between the index and the fund will be within two percent over a year's time. Why 2/3 odds? These figures typically assume a normal probability distribution. Actual probabilities often differ from projections. And probabilities are just that—they're not guarantees.

Dr. Index -

I've been waiting for the chance to trade some of the recently-introduced raft of exchange traded funds, but trading volume seems light. I worry about getting caught flat-footed trading illiquid funds. Won't I pay up to buy them, and take less than fair market when I sell them?

There's really two questions here. ETF pricing can be disconnected from many commonly-held notions of liquidity. ETF liquidity isn't dependent upon how many folks previously traded the issues. These are like mutual funds—open-end portfolios in which shares are continuously created and redeemed by market makers and arbitrageurs. Since new shares can be created by the deposit of stock baskets, ETF liquidity is actually more dependent upon the depth of the markets for the fund components. Futures based upon the ETF's benchmark index further increase fund liquidity, since market makers rely upon the underlying equities markets and futures to hedge their ETF intraday position risks. From this perspective, even ETFs that don't post high daily trading volumes can have surprising depth if there's liquidity in their constituent stocks or related futures. Indexes serving as the bases for both futures and ETFs include:

• S&P 500 Index
• S&P 500/Barra Growth Index
• S&P 500/Barra Value Index
• S&P 400 MidCap Index
• Russell 2000 Index
• Russell 1000 Index
• Nasdaq-100 Index
• Dow Jones Industrial Average

Now... about pricing. Market makers laying down bids and offers know that investors can see fair values for ETFs in real time. ETF share prices—last sale, bid and offer—are disseminated under their unique ticker symbols. Every fifteen seconds, intraday portfolio values are also broadcast under their own distinct symbols. Market makers setting marks at significant variances from intraday portfolio values run the risk of creating arbitrage opportunities exploitable by large traders. Arbitrage is the "self-corrective" force in economic markets that forces the prices of economic equivalents (in this case ETF shares and the fund's underlying portfolio) back into alignment. You can easily tell if you're being shown a fair price for an ETF by monitoring the difference between the intraday portfolio value and the share's bid or offer. Don't like the quote? Use a limit order.

Brad Zigler is head of investor education at Barclays Global Investors Services. Questions can be directed to Dr. Index at http://www.ishares.com/dr_index/.