Archive | Indexes

What Causes an ETF’s Tracking Error?

Last week I explained the importance of monitoring an ETF’s tracking error, which is the difference between a fund’s actual performance and the returns of its index.

The most significant reason index funds lag their benchmarks is the impact of management fees and GST/HST. If your index fund has an MER of 0.25%, you should expect its tracking error to be within a basis point or two of that figure. But it’s often more than that—and sometimes it’s much less. In a series of two posts this week, I’ll look at some real examples from 2012 to illustrate the other factors that can cause an ETF’s returns to vary.

Currency hedging. US and international equity ETFs hedge currency risk using futures contracts. These are renewed every month, and if there’s a dramatic currency movement between contracts—or if the fund experiences a large cash inflow or outflow—that can show up as tracking error. The iShares S&P 500 (XSP) and Vanguard MSCI U.S. Broad Market (VUS) both had tracking errors over 70 basis points in 2012, despite MERs of just 0.24% and 0.17%, respectively.

Currency hedging can also work in the fund’s favour,

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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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New iShares ETFs Give Canadians the World

In an era when ETFs are becoming increasingly narrow and specialized, the new iShares funds launched this week were a pleasant surprise.

Granted, they were late to the game with the iShares S&P 500 (XUS), which is now the fourth ETF that tracks the S&P 500 with no currency hedging. (Vanguard, BMO and Horizons all beat them to market.) But the two international equity ETFs are a lot more interesting. In fact, the iShares MSCI EAFE IMI (XEF) and the iShares MSCI Emerging Markets IMI (XEC) are the most significant index funds to be launched in Canada in at least six months.

We are the 99%

The “IMI” in the name of the international funds stands for Investable Market Index. These MSCI benchmarks are designed to capture 99% of the equity market in a given region, including large, mid, and small cap companies. This is the same strategy used by the Vanguard Total International Stock (VXUS), a core holding in my Complete Couch Potato portfolio.

All three of the new funds simply hold an existing US-listed ETF in the iShares Core Series,

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Ask the Spud: Adding a New REIT to the Index

Loblaw recently announced it will be creating a new real estate investment trust (REIT). Once it goes public, how would it be added to existing real estate ETFs? And considering how large the proposed REIT will be, what effect might it have on ETF shareholders? – Joel H.

On December 6, Loblaw Companies announced it would be turning its vast property holdings into a REIT in the new year. Units in this new trust will be listed on the Toronto Stock Exchange and sold during an initial public offering (IPO) in mid-2013.

Any time a new company is listed on the TSX, it may be considered for inclusion in any number of indexes. For example, stocks in the S&P/TSX Composite Index must meet certain criteria (mainly size and liquidity). The index is reviewed every quarter, and if a company no longer meets these criteria it can be removed. By the same token, any newly listed company that does fit the criteria can be added to the index.

The new Loblaw REIT will be one of the largest in Canada, so it will likely qualify for inclusion in the Composite index.

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Inside the iShares Minimum Volatility ETFs

Last week we looked at two low-volatility ETF strategies based on beta and the standard deviation of daily price movements. Now let’s complete our roundup by looking at a third methodology used by MSCI, the index provider behind the new iShares family of low-volatility ETFs. This is one is completely different from the other two.

MSCI’s strategy is based on creating what’s called a minimum variance portfolio, an idea that goes back to Harry Markowitz’s Modern Portfolio Theory in the 1950s. What makes this strategy unique is that the individual companies don’t matter much in isolation, or even relative to the market as a whole. What’s important is their correlation with each other: the goal is to combine stocks in a way that results in a portfolio with the lowest possible volatility. Think of it like a cake recipe where you add baking powder and salt—which can be unpleasant on their own—because they taste delicious when combined with the other ingredients.

The methodology starts with a parent index that represents the broad market—such as the MSCI Canada Index—and then applies a number of rules to optimize that portfolio.

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Inside the BMO and PowerShares Low-Vol ETFs

In the last 14 months or so, Canada’s ETF providers have launched several funds based on low-volatility strategies. As we saw in my last post, the research suggests it may be possible to build a portfolio of stocks with lower volatility than the broad market without sacrificing expected returns. But exactly how do you select those stocks?

There are several ways to implement a low-volatility strategy, so before you consider any of the new ETFs, make sure you understand how they differ. Today we’ll take a look at the methodologies used by BMO and PowerShares. Next week we’ll look at the iShares strategy.

BMO looks at beta

Rather than tracking an index, the BMO Low Volatility Canadian Equity (ZLB) simply uses a transparent set of rules. You start with the 100 largest stocks in Canada and rank them according to their beta over the previous 12 months. You then select the 40 with the lowest beta: the lower the beta, the greater the company’s weight in the fund. No stock can make up more than 10%, sectors are capped at 35%, and the fund is rebalanced just once a year.

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Barry Gordon on Building an Index: Part 2

In Monday’s post I shared part one of my interview with Barry Gordon, CEO of First Asset, who explained how his firm worked with Morningstar to create new ETF indexes. In part two the interview, Gordon discusses his partnership with PC Bond Analytics, the firm that manages the DEX bond indexes, the most widely followed fixed-income benchmarks in Canada.

Let’s talk about how things worked with your barbell bond ETFs. With the Morningstar equity ETFs there was already an existing methodology. But although the barbell bond strategy is not new, as far as I know there has never been an index.

They know the concept well at DEX, so I went to them and said we want to create these ETFs that replicate a barbell index, do you think you can do that? The process was iterative in the sense that they would come to us with what they thought worked, and I would make suggestions and ask questions based on what we thought was better suited to an ETF. They had to make sure the index was really reflecting what I was trying to do.

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Barry Gordon on Building an Index

Back when dinosaurs roamed the earth, all ETFs tracked well-known third-party indexes like the S&P 500. But it wasn’t long before all of the major benchmarks were spoken for and ETF providers began to commission new indexes for their products. In most cases, they formed partnerships with firms that specialize in index creation, such as Standard & Poor’s, MSCI, Russell, Morningstar and PC Bond Analytics, creators of the well-known DEX bond indexes.

I’ve always been curious about how these new ETF indexes were created, so I called Barry Gordon and asked him to share his experience. Gordon is president and CEO of First Asset, one of the youngest ETF providers in Canada, and he’s launched a handful of funds in 2012. These include four equity ETFs tracking new indexes based on Morningstar’s CPMS strategies, which advisors and portfolio managers use to select dividend, value and momentum stocks. First Asset also launched three bond ETFs using barbell strategies pegged to DEX indexes.

Here’s part one of our interview. I’ll post part two later in the week.

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Vanguard ETFs Get New Indexes

Vanguard has announced it is changing the benchmark indexes on four of its Canadian and 22 of its US ETFs, including some of its most popular funds.

Over the next several months, Vanguard will be stepping away from its relationship with MSCI, one of the world’s largest index providers, and entering new relationships with FTSE and CRSP. I’ll explain these acronyms in a moment, but first let’s have a look at the key funds that will be getting a new benchmark. The full list is available here.

Canadian-listed ETF
New Index

Vanguard MSCI Canada (VCE)
FTSE Canada

Vanguard MSCI US Broad Market (VUS)
CRSP US Total Market

Vanguard MSCI EAFE (VEF)
FTSE Developed ex North America

Vanguard MSCI Emerging Markets (VEE)
FTSE Emerging Index

US-listed ETF

Vanguard Total Stock Market (VTI)
CRSP US Total Market

Vanguard Developed Markets (VEA)
FTSE Developed ex North America

Vanguard Emerging Markets Stock (VWO)
FTSE Emerging Index

Vanguard Total International Stock (VXUS)
FTSE Global All Cap ex US Index

Playing FTSE

The new index providers may not be familiar to Canadians. FTSE (pronounced “footsie”) is a British firm best known for its FTSE 100,

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