How Well Does Your ETF Track Its Index?

The ideal index fund would deliver the precise return of its benchmark, but we all know that’s not realistic. ETFs and index funds may be cheap but they’re not free, and fees almost always cause them to lag slightly. Index investors accept this because they know the alternatives are usually much worse, but they can’t be too complacent. It’s important to periodically check your ETF’s tracking error: that is, the difference between the index return and the fund’s actual performance.

Where do you find this information? Over at iShares, you simply visit the ETF’s web page and click the “Performance” tab. You’ll see the returns of both the fund and its index over various periods from one month to 10 years, as well as calendar-year returns. iShares currently lists fund returns according to net asset value (NAV) only: the market price field is blank. For example, over the 12 months ending March 31 the iShares S&P/TSX Capped Composite (XIC) lagged its index by 29 basis points:

XIC_tracking

The process is almost identical at Vanguard: again, simply visit the ETF’s web page and click the “Performance” tab. Vanguard includes returns based on both NAV and market price, so you can compare both to the benchmark. Here’s what the numbers look like for the Vanguard Canadian Aggregate Bond (VAB):

VAB_tracking

Unfortunately, BMO really drops the ball here. Using the BMO Equal Weight REITs (ZRE) as an example, you can click the Prices & Performance tab and find a link to a Tracking Error Chart, but the info is displayed only in graphical form. You can download an Excel spreadsheet with the raw data, but good luck using that to determine anything useful.

You can’t cover your tracks

Alas, no one can escape the scrutiny of a resourceful Couch Potato. That’s because every mutual fund and ETF in Canada is required to file a Management Report of Fund Performance (MRFP) twice a year. This document includes a lot of valuable information, including your fund’s recent performance in relation to its benchmark. The format is a little different for each company, but the information appears under the heading “Results of Operations.” For 2012, the fund’s MRFP reveals ZRE’s tracking error was 76 basis points:

XRE_tracking

To BMO’s credit, they make it easy to find the MRFPs for all their ETFs on a single web page. (To get there click the “Legal & Regulatory Documents” link at the bottom of any ETF page.) Vanguard also makes your job easy by including an “Annual MRFP” link on the right-hand side of every ETF’s web page. But iShares doesn’t provide a link at all. Neither does Horizons, nor the TD e-Series funds. However, you can always find your fund’s MRFP by visiting SEDAR, where companies are required to post their regulatory documents. Just key in the name of the fund and select “Management Report of Fund Performance” from the pull-down menu.

Next week I’ll share the performance results of some popular index funds, including some pleasant surprises and a few disappointments. I’ll also describe the many factors that contribute to tracking error in your portfolio.

16 Responses to How Well Does Your ETF Track Its Index?

  1. Ken April 18, 2013 at 10:40 am #

    Here are the e-Series numbers I dug up. These are for the past year’s returns.

    Canadian Index e-Series: 6.9%, Benchmark: 7.2%
    Canadian Bond Index e-Series: 3.1%, Benchmark: 3.6%
    US Index e-Series (US$): 15.2%, Benchamrk: 16%
    International Index e-Series: 15.5%, Benchmark: 14.7%

    I could only find the US Index numbers in US$.

    Ken

  2. Value Indexer April 18, 2013 at 11:58 am #

    I’ll have to see if I can get older reports for ZRE and check if the tracking error varies – given that it doesn’t exactly replicate the index some tracking error is expected but if the increased diversification adds value as we expect there should be some times where it does as good as or better than the index.

  3. Canadian Couch Potato April 18, 2013 at 12:18 pm #

    @Ken: For some reason the MRFP for the TD US Index Fund gives the returns in US dollars. But if you drill down to page 7 you’ll see that the unhedged version returned 12.6% last year, compared to the benchmark (S&P 500 in Canadian dollars) of 13.4%. That’s actually pretty poor result.

    @Value Indexer: ZRE doesn’t go back too long, but I include some index data here:
    http://canadiancouchpotato.com/2013/02/11/under-the-hood-vanguard-ftse-canadian-capped-reit-vre/

    Even with the larger tracking error, I think the equal weight strategy is preferable to cap-weighting in this narrow sector.

  4. Ken April 18, 2013 at 1:36 pm #

    @CCP: If the F-series returned 12.6% and it’s MER is 0.56%, would

    F-series return + (F-series MER – e-Series MER)
    12.6 + (0.56 – 0.35) = 12.8%

    be a better estimate of the e-Series US INdex trturn in Canadian dollars, since the returns are reported after fees?

  5. Canadian Couch Potato April 18, 2013 at 1:53 pm #

    @Ken: We should make sure we’re talking about the same thing. The return of the unhedged TD US Index Fund e-Series (TDB902) is easy to find on the fund’s website. It was 12.6%: http://bit.ly/XIQxwJ

    Now the only question is the the benchmark. Bizarrely, the fund’s web page lists this as the S&P 500 in US dollars, which makes no sense, because the fund is unhedged. The MRFP gives the S&P 500 return as 16% in US dollars and 13.4% in Canadian dollars. The latter is the only reasonable benchmark, so the tracking error is 80 bps, which is very high for a fund with an MER of 35 bps.

  6. Nathan April 18, 2013 at 4:21 pm #

    I have to stand up for BMO here and say that given the choice between the raw data they offer and the handful of numbers provided by other firms, I’d go with BMO any day. Of course, having both would be ideal, but that added granularity from BMO is extremely helpful when you want to get into more significant analysis.

  7. Value Indexer April 18, 2013 at 4:33 pm #

    It looks like the index ZRE refers to is actually an equal-weight index, not the cap-weighted one. So that tracking error doesn’t look like it will vary much. It’s a bit more than the MER, which I didn’t realize was so high.

  8. Canadian Couch Potato April 18, 2013 at 4:54 pm #

    @Nathan: The detailed data is only useful to a tiny minority of people, of which I know you’re one. It’s great that they provide so much detail, but there’s no excuse for not also providing the index returns in the usual way. It’s like asking for your bank balance and being handed 50 pages of transactions and being told to calculate it yourself.

  9. Nathan April 19, 2013 at 1:57 am #

    True, true. I guess I understated it saying that providing things both ways would be ‘ideal’. There is certainly no excuse (and no logical reason) for them not to provide the summary numbers. I would just hate for them to take that advice and remove the very useful (to a small number of people, yes :) ) data they currently provide!

  10. Milhouse April 19, 2013 at 2:19 pm #

    Hi Dan, thanks again for an informative article. I hadn’t realized that ETF index tracking is something one ought to be pay close attention.

    Here’s a question for you: Suppose one does find an ETF that tracks a particular index much better than one’s current ETF (or, an ETF that covers more companies one’s current ETF, e.g. VEU vs. VXUS).

    Is it practical for an investor to switch to that other ETF? Are there any transactional costs one might not be aware of, in making that switch? The reason I ask is because once I find an ETF, I like to stick with it, if for no other reason other than ETF manageability (i.e. having to keep track of less ETFs under one’s portfolio).

    Thanks!

  11. Canadian Couch Potato April 19, 2013 at 2:25 pm #

    @Milhouse: The costs of switching would just be the usual trading commissions, though there may also be capital gains taxes to pay. So I should stress that one should only switch if an ETF has a a consistently poor record. Sometimes a fund will have a high tracking error in a given year for a specific reason that isn’t likely to occur again. More on that next week. I fully support your desire to choose a good fund and just stick with it. :)

  12. Milhouse April 19, 2013 at 2:37 pm #

    Hi Dan, when you say, “The costs of switching would just be the usual trading commissions, though there may also be capital gains taxes to pay.”

    In saying “switching”, are your referring to the idea of selling off one’s current ETF holdings, and buying another one, covering the same index?

    What I meant by “switching” is, keeping one’s existing ETF, but then just buying another one covering the same index. For example, I am an investor in VEU, but I might switch to VXUS, in which case, I will just buy VXUS going forward (but hold onto my VEU holdings).

  13. Canadian Couch Potato April 19, 2013 at 2:54 pm #

    @Milhouse: Yes, I was assuming you meant selling the old ETF and replacing it with a new one for that asset class. If you’re comfortable holding both, that’s fine. It just makes the portfolio slightly more awkward to manage.

  14. Colin June 12, 2013 at 6:07 pm #

    I just wanted to note something. Sorry for the lateness (catching up).

    In the snippet of 2012 Management Report of Fund Performance (MRFP) for ZRE that you posted you say the tracking error was 76 basis points.

    But in the next paragraph in that MRFP document it says:
    “The difference in the performance of the ETF relative to the Index during the Period (-0.76%) resulted from the payment of management fees (-0.62%).”

    Wouldn’t that mean the tracking error is 14 basis points?

    Or does tracking error include the MER by definition?

  15. Canadian Couch Potato June 12, 2013 at 7:06 pm #

    @Colin: Tracking error is the difference between the index return and the fund’s returns for any reason, including MER. The idea is that you should tolerate a tracking error as large as the MER: that’s just the cost of investing. An error much larger than the MER can be a cause for concern.

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