XWD & XEM tracking errors much better than they appear

By Dan Hallett, CFA, CFP on July 20th, 2010

Sponsors of exchange-traded funds, or ETFs, generally have websites loaded with great information. I visit the iShares website regularly. One of my favourite tools is iShares’ Tracking Error Chart.  For any iShares fund, it shows you how well each fund has tracked its respective index over various time periods.

The iShares’  Tracking Error Chart would have you believe that XWD has lagged its benchmark by some 10% since its launch just about a year ago.  I found a similar result for iShares MSCI Emerging Markets Index Fund (XEM) – which today shows an annualized tracking error of more than 11% annually since inception.  At first glance, I thought perhaps that these two funds offered hedged exposure to their respective indices and that volatility and hedging imperfections were the culprits.  But I quickly ruled that out given that neither fund holds any derivatives.

XWD simply invests in three NYSE-traded iShares ETFs covering Canadian, U.S. and developed overseas stocks (NYSE Arca symbols are EWC, IVV and EFA respectively).  Similarly, XEM invests solely in the NYSE-traded emerging markets iShares fund (EEM), which in turn holds emerging markets stocks directly.  Neither of these Canadian iShares funds, XWD or XEM, employs any currency overlay.  Each appears to simply exist to appeal to investors who prefer trading on the TSX or for those wealthier investors attempting to skirt U.S. estate taxes.  (Note:  Any Canadian who dies owning a U.S. domiciled fund, even through a Canadian brokerage account, is exposed to U.S. estate taxes.)

iShares ETFs tend to have tracking errors roughly equal to their MERs.  The exceptions are their ETFs tracking hedged foreign exposure, which have had tracking errors around 1% annually.  I discovered that iShares’ Tracking Error Chart compares Canadian dollar performance for XWD and XEM but to the U.S. dollar versions of their respective benchmarks – i.e. the wrong benchmarks.  In fact, each fund tracks the Canadian dollar versions of its benchmarks quite well.  So don’t be fooled by iShares’ tracking error numbers for these unhedged fund-of-funds.

But unless there is a tax reason to stick only to TSX-traded vehicles, U.S. ETFs likely offer the same or broader exposure to global and emerging markets stocks at materially lower fees.