I recently received an email from a reader, J.W., who wanted to know why the tracking error on some popular Vanguard international equity ETFs were so high in 2014. He noted, for example, that the Vanguard FTSE Developed ex North America (VDU) lagged its benchmark index by 1.62% last year, far more than one would expect.

An index fund’s tracking error is the difference between the performance of the fund itself and that of its benchmark. If the index returns 10% on the year and the fund delivers 9.8%, the tracking error is 0.20%, or 20 basis points. But what could possibly cause a fund to show a tracking error of 162 basis points?

Any time you see a surprising number like this, it’s important to determine the reason: otherwise you risk making a bad decision because you’re working with inaccurate or misleading information. If an index were to lag its benchmark by more than 1.6% because it was badly managed, then you should look for a better alternative. But Vanguard has a long record of tight tracking error, so something else has to be going on here—and indeed it is.

Back on track

To understand VDU’s large tracking error—and why it’s not as bad as it looks—let’s look at the reasons its performance deviated so far from the index.

1. Management fees. As we’ve mentioned, this is the most obvious culprit. You should always expect an index fund to lag its benchmark by an amount equal to its management expense ratio, which includes the management fee, taxes and some small incidental costs. VDU’s management fee is now 0.20%, though the full MER was 0.30% in the fund’s mid-year performance report because the new lower fee only came into effect in October 2014.

2. Foreign withholding taxes. International equities are subject to withholding taxes on dividends, which our recent white paper estimated to be about 7.5%. The yield on international developed stocks is quite high—currently close to 3%—so this would shave another 22 basis points or so from the investor’s return. Moreover, because VDU uses a US-listed ETF as its underlying holding, it is subject to an additional 15% withholding tax by the US. Based on the methodology in our white paper, the total impact of these foreign withholding taxes would be close to 0.70%.

Note that you would only bear the full cost of these taxes if you held the fund in an RRSP or TFSA. If you hold VDU in a taxable account, you may be able to recover the Level 2 tax (the portion withheld by the US) by claiming the foreign tax credit on your tax return.

3. Fair value pricing adjustments. The first two components explain about 100 basis points of tracking error. Now for the more complicated part: fair value pricing. I’ve touched on this idea before, both in the context of tracking error and to help explain why the market price and net asset value (NAV) of an ETF can diverge temporarily.

International equity funds such as VDU holds stocks that trade in Europe, Asia and Australia. These markets are rarely, if ever, open at the same time as North American markets. So when the Toronto and New York exchanges close at 4 p.m. local time, the market prices of the stocks are stale. The idea behind fair value pricing is to adjust the closing net asset value of an ETF to reflect what the stocks would be worth if the overseas markets were open. While this may sound manipulative, it’s actually required by US regulators to protect mutual fund investors from “time zone arbitrageurs.”

The thing is, while each fund’s NAV is subject to fair value pricing, the benchmark is not. On volatile days the change in the index may be quite different from the change in the fund’s adjusted NAV. If one of those volatile days happens to be the start or end date of the period you’re measuring, the result can be a significant—but highly misleading— tracking error.

Why you don’t need to worry

Tracking error from management fees and taxes detract from your returns, but fair value pricing adjustments do not. Unless you purchase your entire ETF holding on December 31 of one year and sell it all on December 31 the following year, the tracking error reported for a single calendar year doesn’t mean much at all.

The impact of fair value pricing is highly time-dependent, because on some days the adjustment is much larger than on others. This means that if you shift your start and end dates by just a few days, there’s a good chance the differential will disappear. Moreover, the adjustment can go in both directions: sometimes it increases tracking error while at other times it reduces it.

To illustrate this idea, Vanguard Canada provided the following performance data for the Vanguard FTSE Developed Markets ETF (VEA). It compares calendar year 2014 with one-year numbers using slightly earlier start and end dates. (These returns are reported in US dollars, and international equities had negative returns last year for US investors.)

+1 day 2014 -1 day -10 days
VEA return -4.79 -6.02 -5.23 -1.83
Benchmark return -4.44 -4.85 -4.60 -2.13
Difference -0.35 -1.17 -0.63 0.30
Source: Vanguard

As you can see, the tracking error for VEA in 2014 was 117 basis points. But if you measure the 12-month return using December 30 (-1 day) or January 2 (+1 day) as your start and end dates, the tracking error for the fund looks much smaller. If you use December 17, the tracking error actually appears to be positive.

The message here is that an international equity fund’s true performance needs to be considered in context. Choosing an arbitrary start and end date can produce highly misleading data. So be aware of your ETF’s management fees and withholding tax implications. But if the reported tracking error is significantly higher or lower than that, chances are it’s a result of a fair value pricing adjustment that has no effect on your investment returns.