About a week ago, iShares released its annual Management Reports of Fund Performance, which disclose how well each ETF performed in 2009. I highly recommend that every ETF investor take the time to look at these once a year. You may receive them in the mail from your brokerage, but if not, you can download them anytime from SEDAR. Start by following this link, type the fund company’s name in the search box, then choose “Management Report of Fund Performance” from the pull-down menu.

One of the most useful pieces of information in these reports is the fund’s tracking error. This is the difference between fund’s return and the return of its index benchmark. Each iShares report includes a line like this:

For the year ended December 31, the Fund returned 9.5% versus the Index return of 10%. The main reasons for the difference in performance of -0.5% between the Fund and the Index were management fees (-0.30%) and other miscellaneous factors (-0.20%).

You should fully expect an index fund to trail its benchmark index by the amount of its MER. That’s simply the cost of investing. But an index fund shouldn’t trail its index by much more than that: too many “miscellaneous factors” mean the fund is not well managed.

As you can see from this chart, iShares ETFs generally do a good job tracking their indexes, especially in fixed-income:

Index Fund Tracking
return return MER error
S&P/TSX 60 XIU 31.94% 31.50% 0.17% -0.44%
S&P/ TSX Capped Composite XIC 35.05% 34.46% 0.25% -0.59%
Dow Jones Select Dividend XDV 37.83% 36.90% 0.50% -0.93%
Dow Jones Select Growth XCG 22.84% 22.17% 0.50% -0.67%
Dow Jones Select Value XCV 44.87% 43.81% 0.50% -1.06%
REIT Sector XRE 55.25% 53.50% 0.55% -1.75%
S&P 500 (hedged) XSP 24.08% 22.95% 0.24% -1.13%
MSCI EAFE  (hedged) XIN 23.45% 18.11% 0.49% -5.34%
DEX Universe Bond XBB 5.41% 4.98% 0.30% -0.43%
Short-Term Bond XSB 4.54% 4.34% 0.25% -0.20%
Long-Term Bond XLB 5.49% 5.31% 0.35% -0.18%
Government Bond XGB 1.57% 1.22% 0.35% -0.35%
Corporate Bond XCB 16.26% 15.10% 0.40% -1.16%
Real-Return Bond XRB 14.50% 14.13% 0.35% -0.37%

One thing jumps out from these numbers: the iShares MSCI EAFE Index Fund (XIN), which holds stocks in developed countries overseas (Europe, Japan, Australia) has an enormous tracking error of -5.34%. When I looked at similar international funds from Claymore, TD and Vanguard, I found tracking errors in the same range, which is very unusual. This leads me to think there was some anomaly in the international markets during 2009 that made the indexes difficult to track. I’m looking into the issue and will report back when I know more.