Tracking error—the difference between the performance of a fund and that of its benchmark—is the best way to measure an index fund’s true cost. While many investors focus on MERs, a low fee means little if an ETF lags its index by an additional 30 or 40 basis points.

A couple of weeks ago, I reported on the tracking errors of iShares ETFs in 2011, which were mostly very low. Today let’s look at the 2011 performance of the most popular ETFs that formerly bore the Claymore name, all of which were recently rebranded as iShares.

Canadaian equity Ticker Fund Index Diff
Canadian Fundamental CRQ -8.3% -7.9% -0.4%
S&P/TSX Canadian Dividend CDZ 6.3% 7.4% -1.1%
US and international equity Ticker Fund Index Diff
US Fundamental (hedged) CLU -1.5% -0.4% -1.1%
US Fundamental CLU.C 1.8% 2.3% -0.5%
International Fundamental CIE -13.1% -12.2% -0.9%
BRIC CBQ -22.5% -22.0% -0.5%
Global Real Estate CGR -3.1% -2.0% -1.1%
Global Monthly Advantaged Dividend CYH -5.5% -5.7% 0.2%
Fixed income Ticker Fund Index Diff
1–5 Yr Laddered Corp Bond CBO 4.7% 5.0% -0.3%
1–5 Yr Laddered Gov’t Bond CLF 5.4% 5.5% -0.1%
Advantaged Canadian Bond CAB 6.8% 8.9% -2.1%
Advantaged High Yield Bond CHB 4.6% 6.4% -1.8%

Let’s start with the positive results: the three core equity funds tracking the RAFI fundamental indexes had very low tracking errors. The Canadian Fundamental (CRQ) and the non-hedged version of the US Fundamental (CLU.C) both lagged by less than their MERs, which is always impressive. The International Fundamental (CIE) didn’t fare quite as well, but the higher costs of trading international equities makes this unsurprising.

Once again, currency hedging proved to be a major drag on performance: the hedged version of the US Fundamental (CLU) had a tracking error 60 basis points higher than that of CLU.C. Remember that this added friction will be there whether the Canadian dollar rises or falls during the year.

The performance of both CLU.C and CIE are very encouraging, given that both funds have experienced terrible tracking errors in the past. I currently recommend the US-listed PowerShares fundamental ETFs in my Über-Tuber portfolio because of this poor track record. But now that these funds hold all of the stocks in their indexes (as opposed to a representative sample, as in years past) they seem to be doing an excellent job of mirroring their benchmarks. Next time I update the model portfolios I will have to consider including CLU.C and CIE.

Not such an advantage

The Claymore/iShares Advantaged ETFs, which hold either bonds or foreign dividend paying stocks, are designed to be as tax-efficient as possible. I include three of them in my Yield-Hungry Couch Potato, which is designed for non-registered accounts.

The performance of these funds was mixed. The Global Monthly Advantaged Dividend (CYH) actually had a higher return than its benchmark, which is a pleasant surprise. But the Advantaged Canadian Bond (CAB) and the Advantaged U.S. High Yield Bond (CHB) lagged their indexes by 2.1% and 1.8%, respectively.

The Advantaged funds have higher expenses and should be expected to have bigger tracking errors than their plain-vanilla counterparts—even then the tax advantages might still put them ahead. But for investors who are not in the highest tax bracket, the “advantage” is likely to be slim to zero when tracking errors are this high. The comparable iShares DEX Universe Bond (XBB) returned 9.36% in 2011, while the iShares U.S. High Yield Bond (XHY) returned 6.83%. It’s quite possible the after-tax returns on these traditional ETFs may have been higher for investors who were not in the highest tax brackets.

I consider these Advantaged bond funds to be on probation: if they continue to lag like this, I will remove them from my model portfolio.