It’s report card time in the investment fund world. Every year at this time, all mutual funds and ETFs are required to file a Management Report of Fund Performance, a document that contains a wealth of useful information. (They’re available from the SEDAR website.) If you’re an index investor, one of the most important things you can learn is a fund’s tracking error.

Tracking error is the difference between the performance of the fund’s underlying index and that of the fund itself. Remember, the goal of an index fund is to deliver the returns of a particular asset class, as measured by an index. If a fund does a consistently poor job of that, it’s time to start looking for another option.

iShares released its MRFPs yesterday, and I looked up the tracking errors for a number of their most popular ETFs:

Canadian equity ETF Ticker Fund Index Error
iShares S&P/TSX 60 XIU -9.23% -9.08% -0.15%
iShares S&P/TSX Capped Composite XIC -8.93% -8.71% -0.22%
iShares S&P/TSX Completion XMD -8.33% -7.85% -0.48%
iShares S&P/TSX SmallCap XCS -16.66% -16.43% -0.23%
iShares DJ Canada Select Dividend XDV 3.49% 4.09% -0.60%
iShares S&P/TSX Capped REIT XRE 20.95% 21.67% -0.72%
Global equity ETF Ticker Fund Index Error
iShares S&P 500 XSP 1.07% 1.71% -0.64%
iShares MSCI EAFE XIN -12.71% -12.12% -0.59%
iShares MSCI Emerging Markets XEM -17.09% -16.40% -0.69%
iShares MSCI World XWD -3.57% -3.20% -0.37%
Fixed income ETF Ticker Fund Index Error
iShares DEX Universe Bond XBB 9.38% 9.67% -0.29%
iShares DEX All Government Bond XGB 9.82% 10.20% -0.38%
iShares DEX All Corporate Bond XCB 7.51% 8.24% -0.73%
iShares DEX Short Term Bond XSB 4.42% 4.65% -0.23%
iShares DEX Real Return Bond XRB 17.87% 18.35% -0.48%
iShares U.S. IG Corporate Bond XIG 10.40% 11.85% -1.45%

Sizing up the performance

Canadian equities: You should expect a Canadian equity index fund’s tracking error to be about as large as its MER—perhaps a few basis points more. The iShares ETFs have exceeded expectations here: XIC, XIU, XMD and XCS all have tracking errors lower than their annual fees. That means the fund managers not only tracked the indexes perfectly, they even managed to add a little value, probably through activities such as securities lending and arbitrage. This is top-shelf performance.

US equities: Tracking foreign equities is always more difficult due to withholding taxes. But it’s currency hedging that creates the biggest drag on fund’s like XSP.  The fund’s tracking error was –0.64%, despite an annual fee of just 0.25%. But there’s more: XSP’s index accounts for the currency hedging strategy, which is reset each month, and this index returned 1.71%. However, the S&P 500’s actual return in US dollars was 2.11% last year. So the true underperformance of XSP was –1.04%. Over the last seven years, this performance gap has averaged more than 2%. This is why I don’t recommend currency hedging. (Note that the two international iShares ETFs that do not use hedging—XEM and XWD—both had tracking errors lower than their MERs.)

Fixed income: The two largest bond funds, XBB and XSB, also had tracking errors lower than their MERs, another excellent result. The corporate bond ETFs did not make out so well. It is actually much more difficult to track a corporate bond index than many investors realize. As a result, XCB’s tracking error has averaged –0.82% over the last five years, despite an MER of 0.42%. XIG, which tracks US investment-grade corporates with currency hedging added, shows a huge tracking error of –1.45%, but it outperformed its underlying ETF in US dollar terms (10.40% versus 8.89%). I admit that one has me baffled.

I’ll have more tracking error reports to share next week when all the documents are available.