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,