Tracking Errors on US and International ETFs

The table below shows the tracking error of U.S. and international equity ETFs in 2010.

To make sure you understand these numbers in their proper context, see yesterday’s post about tracking errors on Canadian equity ETFs.

		Fund	Index	Tracking
US equity (hedged)	Ticker	return	return	error
iShares S&P 500	XSP	13.5%	13.5%	0.0%	(1)
TD US Index Currency Neutral – e	TDB904	12.6%	13.5%	-0.9%
RBC US Index Currency Neutral	RBF558	12.6%	15.1%	-2.5%
Altamira US Index Currency Neutral	NBC856	13.0%	15.1%	-2.1%
Claymore US Fundamental	CLU	16.7%	18.3%	-1.6%	(2)
BMO US Equity	ZUE	11.2%	11.8%	-0.7%
BMO Dow Jones Industrial Average	ZDJ	11.9%	12.8%	-0.9%
Horizons S&P 500 Index	HXS	6.7%	6.5%	0.2%	(3)

US equity (non-hedged)
Claymore US Fundamental	CLU.C	11.8%	14.1%	-2.3%
TD US Index – e	TDB902	8.4%	9.2%	-0.8%
RBC US Index	RBF557	8.0%	9.2%	-1.2%
Altamira US Index	NBC846	7.5%	8.3%	-0.7%

International equity (hedged)
iShares MSCI EAFE	XIN	4.6%	4.6%	0.0%	(4)
TD Int’l Index Currency Neutral – e	TDB905	4.0%	4.8%	-0.8%
RBC Int’l Index Currency Neutral	RBF559	3.3%	4.8%	-1.5%
BMO International Equity	ZDM	1.1%	5.7%	-4.6%	(5)
Claymore Japan Fundamental	CJP	-1.9%	0.4%	-2.3%	(6)

International equity (non-hedged)
Claymore International Fundamental	CIE	-0.2%	1.9%	-2.1%	(2)
TD International Index – e	TDB911	1.7%	2.1%	-0.4%

Emerging markets equity
iShares MSCI Emerging Markets	XEM	10.0%	12.7%	-2.7%
BMO Emerging Markets Equity	ZEM	11.9%	15.3%	-3.4%	(5)
Claymore Broad Emerging Markets	CWO	16.2%	19.2%	-3.1%	(7)
Claymore BRIC	CBQ	8.8%	11.6%	-2.9%

Miscellaneous
Claymore Global Advantaged Dividend	CYH	11.1%	13.9%	-2.8%
Claymore Global Real Estate	CGR	13.1%	14.9%	-1.7%
iShares MSCI World	XWD	5.7%	5.9%	-0.2%

Notes:

1. The first four funds in this list all track the S&P 500 with currency hedging. However, you’ll notice that the iShares S&P 500 Index Fund (XSP) and TD’s U.S. Index Currency Neutral Fund report the index return as 13.5%, while the RBC and Altamira funds measure their performance against an index return of 15.1%. Why the difference?

The S&P 500 returned earned 15.1% in US dollars last year, and the latter two funds use this benchmark. However, XSP and the TD fund track the S&P 500 Hedged to Canadian Dollars Index, which factors in the currency hedging, reset once a month. That makes it a more realistic benchmark for the fund managers.

However, as S&P explains: “It is important to remember that since only beginning-of-period balances are hedged, the index does not assume a perfect hedging of currency movements.” That means Canadian investors should not expect the same returns from the S&P 500 that US investors enjoy. Indeed, here’s how XSP performed compared with the S&P 500 in US dollars over the last six years:

	S&P 500	XSP
	in USD	in CAD	Difference
2010	15.1%	13.5%	-1.6%
2009	26.5%	23.0%	-3.5%
2008	-37.0%	-40.3%	-3.3%
2007	5.5%	3.2%	-2.3%
2006	15.8%	14.3%	-1.5%
2005	4.9%	3.5%	-1.4%

2. Claymore’s US Fundamental ETF (CLU) and International Fundamental ETF (CIE) had enormous tracking errors in 2009. Both improved greatly in 2010, but they still lagged their indexes significantly. Until recently the two funds held only a sampling of the stocks in their indexes. However, in 2010, both funds filled in those gaps, increasing their holdings from fewer than 400 stocks to about 1,000. Going forward, the tracking errors on these funds should be much smaller.

3. The Horizons S&P 500 Index ETF (HXS) was launched in late November 2010, so this tracking error covers only a few weeks. However, the structure of HXS, which uses a swap to deliver the total return of the S&P 500, hedged to Canadian dollars and with no withholding taxes, should guarantee that the tracking error will not exceed 0.5%. That takes into account its 0.17% MER and the additional cost of the swap.

4. The iShares MSCI EAFE Index Fund (XIN) tracks an index that has the currency hedging strategy built in, following the same principal as XSP (see note 1). The competing international index funds from TD and RBC track the MSCI EAFE index with returns measured in their local currencies. Here XIN’s benchmark really does make more sense, since the EAFE index includes many different currencies, so no investor could possibly achieve local returns in all of them.

5. BMO’s two international equity funds (ZDM for developed markets, and ZEM for emerging markets) both used representative sampling in 2010. The managers were not very successful in this respect, and the tracking errors were large. However, this will probably improve as the fund grows in size.

6. Claymore’s Japan Fundamental ETF (CJP) returned –1.88% in terms of net asset value, but if you held this fund in your portfolio, its market price went down an alarming –5.49%. It’s unusual for these two returns to differ so widely. What happened here was that the Claymore International Fundamental ETF (CIE) used to hold CJP for its exposure to Japanese stocks. But in April 2010, CIE sold off this holding—which was over $15 million—and started buying up the individual stocks (see note 2). The market impact of this move helped drive down the price of CJP.

In addition, later in the year CJP itself increased its holdings by about 100 stocks in order to replicate its index more closely. It seems reasonable to expect the funds tracking error to improve in the future.

7. Claymore’s CWO had the highest returns of the emerging markets ETFs in 2010. However, the outperformance was due to the ETF’s unusual strategy of hedging against the US dollar in order to match the returns of Vanguard’s Emerging Markets ETF (VWO). In this respect, it underperformed by more than 3%.