Archive | April, 2010

International Tracking Error: Part 2

International index funds and ETFs showed large tracking errors in 2009. In my first post on this topic, I explained how the time differences between North American and overseas markets can make it appear as if international funds are not tracking their indexes closely. Now let’s look at another reason that international ETFs can diverge from their index: representative sampling.

Many ETFs track their underlying indexes almost perfectly. For example, S&P 500 funds generally hold all 500 stocks in the index, in almost the exact same proportions. The iShares S&P/TSX 60 Index Fund (XIU), too, holds all 60 companies in this Canadian large-cap index. But few international indexes are as easy to track as these popular benchmarks. Sometimes it’s because the indexes are much larger, but mostly it’s because overseas stocks are often less liquid and more expensive to trade.

For example, the MSCI EAFE Index — the most popular yardstick for developed markets in Europe, Australasia and the Far East — includes 952 companies in 21 countries. The MSCI Emerging Markets Index, meanwhile, includes 765 stocks in 24 nations. As you can imagine, managing a portfolio of that many stocks,

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International Tracking Error: Part 1

In a previous post, I pointed out that many international equity ETFs showed large tracking errors in 2009. For example, the iShares MSCI EAFE Index Fund (XIN), which tracks European and Japanese stocks, trailed its benchmark index by 5.34%. The comparable Vanguard Europe Pacific ETF (VEA) also lagged by 3.44%.

I contacted iShares, Vanguard and Claymore to ask how their international ETFs got so far off track last year. The answers turned out to be varied and complicated, so I’ll take a couple of posts to explain them.

The first point to understand is that the net asset value (NAV) of international funds can be temporarily distorted because of the time differences between North America, Asia and Europe. The Tokyo markets close at 1 a.m. Eastern Standard Time, while the London Stock Exchange closes at 11:30 a.m. EST. By the time the US and Canadian markets stop trading at 4 p.m., the Asian markets have been already been closed for 15 hours, and the European markets for four-and-a-half hours.

International indexes are calculated using the end-of-day prices of stocks in their native country, but a Canadian or American ETF tracking that index will continue to trade after those overseas markets are closed.

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Review: Why Smart People Make Big Money Mistakes

To be successful with money, it’s not enough to have a good strategy. You also need to avoid the emotional and psychological traps that snare so many investors. Gary Belsky and Thomas Gilovich examine these pitfalls in their eminently readable book on behavioural economics, Why Smart People Make Big Money Mistakes (Simon and Schuster).

The book was originally published in 1999, but it has been extensively revised and updated. Of course, human nature hasn’t changed in the years since the book first appeared. See if you recognize yourself in any of these logical fallacies and psychological pitfalls:

Mental accounting. I admit I fell prey to this one when I opened a Tax-Free Savings Account to sock away some cash. I soon realized this made little sense when I was carrying a mortgage with an interest rate higher than what I would earn from my savings. So I closed the account and made a mortgage prepayment instead. Mental accounting makes you feel like you’re saving, even when you’re actually losing money by ignoring your debt. A similar lapse in logic occurs when we are reluctant to sell stocks inherited from a parent,

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An Easy Way to Buy the World

When you’re investing a relatively small amount of money — in an RESP or a Tax-Free Savings Account, for example — it pays to keep things simple. That’s especially true if you’re buying ETFs from one of the big banks’ discount brokerages. Those $30 trading fees are significant, and if your portfolio holds eight to ten ETFs, each with only a few thousand bucks, adding new money and rebalancing quickly gets expensive.

I recently looked for a way to simplify the international allocation in my own portfolio. I use Vanguard ETFs for all my foreign equity holdings: 42.5% in Vanguard Total Stock Market (VTI) for the United States, 42.5% in Vanguard Europe Pacific (VEA), and 15% in Vanguard Emerging Markets (VWO). I wondered if it made more sense to simply use Vanguard’s Total World Stock Market (VT) instead. This single ETF would eliminate the need to rebalance, and I could make just one contribution a year rather than three.

The first step in my comparison was to see whether the country weightings in VT are similar to the mix I had with the three individual ETFs.

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Tracking Errors on Claymore ETFs

In my previous post, I looked at the tracking errors on iShares ETFs in 2009. In this edition, we’ll look at how Claymore’s ETFs tracked their indexes last year.

Tracking error is the amount by which the fund’s actual return trails (or exceeds) the return of the index. This information is reported in the fund’s annual Management Report of Fund Performance, which you can download from SEDAR. Just follow this link, type the fund company’s name in the search box, then choose “Management Report of Fund Performance” from the pull-down menu.

In Claymore’s reports, look for the heading “Results of Operations,” which is followed by a paragraph like this:

For the one year period ended December 31, 2009, the ETF’s common class units generated a total return of 10% on a NAV basis, representing a change in NAV per unit to $11 on December 31, 2009 from $10 on December 31, 2008… For the same period, the Index returned 11%.

In the above example, where the fund returned 10% and its index returned 11%, the tracking error is 1%. You should expect an index fund or ETF to trail its benchmark by the amount of its MER,

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Tracking Errors on iShares ETFs

About a week ago, iShares released its annual Management Reports of Fund Performance, which disclose how well each ETF performed in 2009. I highly recommend that every ETF investor take the time to look at these once a year. You may receive them in the mail from your brokerage, but if not, you can download them anytime from SEDAR. Start by following this link, type the fund company’s name in the search box, then choose “Management Report of Fund Performance” from the pull-down menu.

One of the most useful pieces of information in these reports is the fund’s tracking error. This is the difference between fund’s return and the return of its index benchmark. Each iShares report includes a line like this:

For the year ended December 31, the Fund returned 9.5% versus the Index return of 10%. The main reasons for the difference in performance of -0.5% between the Fund and the Index were management fees (-0.30%) and other miscellaneous factors (-0.20%).

You should fully expect an index fund to trail its benchmark index by the amount of its MER. That’s simply the cost of investing.

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Introducing Passive Aggressive Solutions™

[Note: This post was an April Fool’s joke!]

If you’re a disciple of the Couch Potato strategy, chances are that you handle your own investments without an advisor. And that’s the right decision for many people. However, over the past few months, I’ve received many emails from readers who need the advice of a professional to help them achieve their financial goals.

That’s why I’m pleased to announce my new investment advisory service, Passive Aggressive Solutions™. I want to help you take Couch Potato investing to the next level: after all, in difficult markets like these, settling for average just isn’t good enough.

Here’s how the service works: I’ll start by helping you build an individually tailored portfolio of low-cost ETFs or index funds, using a proprietary algorithm I designed using Excel. That’s the passive part. Then I’ll implement aggressive strategies designed to earn above-market returns—something you can’t do with index funds. It’s like having your cake and eating it, too.

Of course, I want a slice of the cake. But the business model for Passive Aggressive Solutions™ is unique. My original goal was to charge a flat fee,

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