Archive | Index funds

When You Can Ignore Tracking Error

In Monday’s post, I reviewed the major factors that contribute to an index fund’s tracking error. Here are some other things to consider when you’re comparing your fund’s performance to that of its benchmark. These can cause tracking errors to seem unusually large or small, but they need to be understood in context.

Changes to the index. A number of ETFs changed their benchmark index during 2012, including some core equity funds from BMO and Vanguard. When there is an index change in the middle of the year, measuring tracking error becomes difficult and the numbers can be misleading. Until late September, the BMO S&P 500 Hedged to CAD (ZUE) held just 100 large-cap stocks selected using a different methodology. ZUE ended up lagging the S&P 500 by less than its management fee, which is normally an excellent result, but in this case it was a fluke.

A small number of ETFs in Canada are not tied to any third-party benchmark. The BMO Canadian Dividend (ZDV), for example, includes 30 stocks selected using an in-house methodology. In cases like this,

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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:

The process is almost identical at Vanguard: again, simply visit the ETF’s web page and click the “Performance” tab.

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Why Index Mutual Funds Still Have a Place

Responding to a recent article on mutual funds by Rob Carrick, a Globe and Mail reader rehashed a common refrain: “Perhaps mutual funds were once a great way for ‘average Canadians’ to invest, but they have been totally subverted by the greed and mediocrity of the financial institutions who dominate the field … Canadians are generally far better served by ETFs.”

The problem with remarks like this is they present the debate as “mutual funds versus ETFs,” and that’s the wrong way to think about it. The mutual fund industry in this country has enormous problems, to be sure: some of the highest fees in the world, deferred sales charges, and bad advice from salespeople with vested interests. These are all disgraceful practices, but they have little or nothing to with the mutual fund structure.

Index investors have broken free of the worst industry practices, but they still seem reluctant to embrace mutual funds. For example, when Scotia iTrade began offering Claymore (now iShares) ETFs without commissions, I heard from many folks who couldn’t wait to get on board.

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Ask the Spud: Combining e-Series Funds and ETFs

I use the Global Couch Potato with e-Series funds in my TD Waterhouse account, but I eventually want to use the Complete Couch Potato. Once my portfolio gets to $50,000 and I qualify for $9.95 trading commissions, should I move everything to ETFs? — Mark V.

If you’re a client of any other brokerage, it makes sense to use ETFs to build the Complete Couch Potato portfolio. But with TD Waterhouse you have the unique opportunity to combine the e-Series mutual funds and ETFs in the same account. For five-figure portfolios (and perhaps even much larger accounts) a hybrid approach is likely to make more sense than using all ETFs.

The Complete Couch Potato has three asset classes that are absent in the Global Couch Potato: real estate, real-return bonds, and emerging markets. There are no e-Series funds for these asset classes, nor are there low-cost index funds from other providers. But that doesn’t mean you can’t create a hybrid portfolio of e-Series funds and ETFs. It would look something like this:

Asset class

Fund name (ticker)

Canadian equity

TD Canadian Index – e (TDB900)

US equity

TD US Index – e (TDB902)

International equity

TD International Index – e (TDB911)

Emerging markets equity

Vanguard MSCI Emerging Markets  (VEE)

Real estate

BMO Equal Weight REITs (ZRE)

Real return bonds

iShares DEX Real Return Bond (XRB)

Canadian bonds

TD Canadian Bond Index – e (TDB909)



A few words of explanation.

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Another 5 Underrated Index Funds

Last week I presented a list of five Canadian ETFs I feel are underused compared with their billion-dollar competitors. Here’s are three more ETFs and a couple of index mutual funds I’d put in the same category.

1. PowerShares FTSE RAFI Canadian Fundamental (PXC)

The iShares Canadian Fundamental (CRQ) has been a high-profile ETF since it was launched in 2006, and it has outperformed the S&P/TSX Composite Index by more than 1% a year for the last five, despite a relatively high fee of 0.72%. This new PowerShares ETF, launched with little fanfare in January 2012, is tied to the exact same index as CRQ, but with a significantly lower management fee (0.51% including HST). Assuming it will track the index well and overcome the problems associated with low trading volume—and it’s too early to tell—it may be a compelling alternative for investors interested in fundamental indexing.

2. BMO Low Volatility Canadian Equity (ZLB)

I’ll start by saying I’m agnostic about low-volatility ETFs, as I’m still looking deeper into the research. But there is some evidence suggesting stocks with low beta—that is,

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Foreign Withholding Tax: Which Fund Goes Where?

My previous post on foreign withholding taxes included a lot of information for investors to puzzle over. But unless you’re an accountant, you probably don’t care too deeply about the finer details. Most investors just want to answer a simple question: which fund should I put in which account?

Recall from the earlier post that there are five broad categories of funds you can use for US and international equities:

A. Canadian mutual fund or ETF that holds US or international stocks directly.
B. US-listed ETF that holds US stocks.
C. US-listed ETF that holds international stocks.
D. Canadian ETF that holds a US-listed ETF of US stocks.
E. Canadian ETF that holds a US-listed ETF of international stocks.

To help you make the most tax-efficient choice for each type of account, see the tables below. I’ve specified which of the above fund categories are the most tax-efficient, and which ones carry the largest withholding tax burden. Then I’ve included some comparisons of specific funds. In each case, the pairs track the same index and use the same currency hedging strategy. Once again, a big thanks to Justin Bender at PWL Capital for helping me sort through these details.

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Foreign Withholding Tax Explained

The Couch Potato strategy calls for a significant allocation to US and international stocks. When you live in a country with a small, poorly diversified stock market, global diversification is extremely important. But it does carry a price in the form of foreign withholding taxes.

Many countries levy a tax on dividends paid to foreign investors: the rate varies, but for US stocks it is 15%. (Foreign withholding taxes do not apply to capital gains.) With broad-based US index funds now yielding about 2%, the withholding tax amounts to an additional cost of 30 basis points. As you can see, the impact of withholding taxes can be far greater than that of management fees, which get a lot more attention.

To learn how much tax is withheld by your fund, click the “Distributions” tab on its web page and look under the heading “Foreign Tax Paid.” Here’s what the table looks like for the iShares S&P 500 (XSP). Notice the amount of tax paid for 2011 ($0.04388 per share) is approximately 15% of the foreign income received ($0.26866):

Investors and advisors are often unaware of how foreign withholding taxes affect returns,

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Comparing the Costs of Index Funds and ETFs

[Note: This post was updated in May 2014 when the ING Direct Streetwise Funds changed their name to the Tangerine Investment Funds.]

The growing popularity of index investing has a lot to do with the increasing number of ETFs available, and that’s largely a good thing. ETFs generally have lower management expense ratios (MERs) than index mutual funds in Canada, so they are usually the best choice for large portfolios, especially if you make infrequent lump-sum contributions.

But ETFs carry additional costs that are often ignored by beginning investors. Trading commissions are the most obvious: it typically costs $10 to buy or sell ETFs, while index mutual funds can be traded for free. (Some brokerages do offer a limited selection of commission-free ETFs, and a few independents offer trades for less than $10.)

Are index funds or ETFs right for you?

All of which is to say that as marvelous as ETFs are, they are often inferior to index mutual funds for investors with small accounts. My rough minimum for using ETFs is $50,000, but the actual cut-off varies a lot depending which specific ETFs or index funds you use,

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Inside the DFA Global Balanced Fund

Long-time readers will know that I’ve written before about Dimensional Fund Advisors, an innovative investment firm that builds low-cost, widely diversified funds. I enjoy keeping an eye on DFA, because their strategies are based on academic research (there are a few Nobel laureates in the family) that all investors can learn from.

The one downside of Dimensional funds is that they’re not available through discount brokerages: the only way you can get them is through a small number advisors who have been schooled in DFA’s strategies. This helps the company control fund inflows and outflows from performance-chasing retail investors that would make executing those strategies impossible.

But that doesn’t mean Couch Potatoes can’t pop the hood on these funds and take a look. Just shy of a year ago, the firm launched the DFA Global Balanced Fund in Canada: it’s a fund of funds that includes the standard 60% equity and 40% bonds. [Note: This fund’s name has been changed to the DFA Global 60EQ-40FI Portfolio. There are now also versions with different allocations to equity and fixed income.] The I thought it would be interesting to compare it to my own Complete Couch Potato.

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