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,