According to a new report from Morgan Stanley, tracking error among exchange-traded funds widened significantly in 2009, as volatile markets, diversification requirements, optimization strategies and large movements in small-cap companies combined to cause many ETFs to miss their benchmarks.

Tracking error for U.S.-listed ETFs averaged a shocking 1.25 percent in 2009, up from 0.52 percent in 2008, Morgan Stanley said. On an asset-weighted basis, tracking error widened from 0.39 percent to 1.13 percent.

Morgan Stanley considers tracking error as any deviation (positive or negative) from the return of a fund’s benchmark index. Viewed through this lens, investors should always expect some tracking error in their funds, as the drag of expenses will cause most ETFs to lag their benchmarks over time.

In some areas of the market—such as U.S. major market and U.S. style funds—ETFs actually performed admirably, delivering tracking errors below their weighted average expense ratios. Currency funds and U.S. dividend products delivered similar results.

But in other areas, including U.S. sector and industry funds, global funds, commodity and fixed-income products, ETFs fell behind.

Morgan Stanley attributed the increase in tracking error to many factors.

In some cases, ETFs are doomed to tracking error by Securities and Exchange Commission diversification requirements. For instance, the fund with the largest tracking error in the study was the Vanguard Telecom Services ETF (NYSEArca: VOX), which actually outperformed its benchmark by 17.09 percent. That massive miss was driven by the fact that its benchmark—the MSCI US Investable Market Telecommunications Services Index—has a 49 percent weight in AT&T, while VOX is limited by SEC rules capping individual security positions at 20 percent of the portfolio. With AT&T performing poorly last year, VOX benefitted by underweighting the company in its portfolios.

Other funds caught up in regulatory loopholes last year included the PowerShares Global Listed Private Equity Portfolio (NYSEArca: PSP), which lagged its benchmark by 13.68 percent due to tax rules that force it to periodically liquidate large parts of its portfolio.

In other cases, ETFs make an active decision to optimize their portfolios, either for trading or creation/redemption purposes, which led to significant tracking problems in 2009. The Shares MSCI Emerging Markets Index Fund (NYSEArca: EEM), for instance, holds only about half of the number of securities in its benchmark index. This optimization strategy helps support the fund’s remarkable liquidity, at the cost last year of returns: EEM trailed the fund’s benchmark by more than 6 percent in 2009.

In general, Morgan Stanley said the wide variance in performance by small-cap names in 2009 caused funds that used optimization strategies—which often underweight smaller, less liquid securities—to experience significantly more tracking error than normal. Funds that use full replication tend to track their benchmarks more closely.