Tracking Error in Index Funds

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Gus
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Post by Gus »

Norbert Schlenker wrote:
Icarus wrote:it's not isolated to XRB. XRE, XCB and XSB have come off the rails, too.
I'm assuming it's an accounting anomaly but I have an inquiry into BGI. The break on XRB is overnight 16-17 Dec, 17 Dec is the date the year end income distributions were announced, the amounts approximately match, etc. Distributions should be paid tomorrow so I'm trusting that the tracking error goes back to ~zero no later than Friday.
I made an enquiry to iShares as well. Their reply did nothing to assuage my concerns, quite the contrary:
iShares wrote:Thanks for contacting us about iShares ETFs. With regard to your request, our fixed income products do not hold all of the bonds but a slice of the index. Over the past year, issuer specific risk has been more prevalent than before because of the added volatility in the market. Therefore, not holding all of the bonds has caused the fund's return to not fully mirror the return of the index.
IMO that can't be the right answer since all their bond funds (short, long, corporate and real return) show the same recent drift, so "issuer specific risk" is surely not the cause. I'll follow up.
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tidal
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Post by tidal »

even the XGB's seem to have gapped, so let's hope it is related to distributions... but I find it disturbing as well...

and i still don't get how the XIC's and others went to such extremes on October 14...
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Norbert Schlenker
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Post by Norbert Schlenker »

tidal wrote:even the XGB's seem to have gapped, so let's hope it is related to distributions... but I find it disturbing as well...
Honestly, I think it's an accounting problem. AFAIK the distribution is not legally a liability until the record date (the ex-div date if you're actually trading) but BGI has booked it as such on the declaration date. That whacks the NAV. If this were an open-ended fund, BGI would IMO be legally liable for the mismark. Exchange traded, it's just something else for the unwary to be caught by.
and i still don't get how the XIC's and others went to such extremes on October 14...
That's an order matching problem at the open on the TSX. FWIW it happens on other exchanges too (although usually not to that degree).
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tidal
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Post by tidal »

Norbert Schlenker wrote:
tidal wrote:and i still don't get how the XIC's and others went to such extremes on October 14...
That's an order matching problem at the open on the TSX. FWIW it happens on other exchanges too (although usually not to that degree).
Why weren't the designated market participants closing the gap? I'm still miffed as to how this occurred. I "get" why individual stock issues could get into big problems with order matching, but as i understood the etf creation and redemption process, this "should" not have happened to the iShares... bwtfdik...
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Post by Icarus »

Gus wrote:I made an enquiry to iShares as well. Their reply did nothing to assuage my concerns, quite the contrary:
I received a similar non-reassuring reply, but they gave me a different explanation. I was told that it depends on supply and demand of XRB. That didn't make sense to me, because the creation and redemption process (as I understand it) should keep the NAV in line regardless of the liquidity of the ETF providing the underlying securities are liquid enough. Retail investors may fall for it, but arbitrageurs should not be leaving free money on the table.

I've been thoroughly unimpressed with responses that I've received from Barclay's over the years. One time the guy on the phone told me I was wrong about something, then called me back to tell me I was right after he spoke to someone who actually knew something. I don't think the answers are worth much.
Honestly, I think it's an accounting problem. AFAIK the distribution is not legally a liability until the record date (the ex-div date if you're actually trading) but BGI has booked it as such on the declaration date. That whacks the NAV.
I think this must be true since the arbitrageurs should have brought the price down otherwise by buying the cheaper underlyings and selling Barclay's a creation unit. Still, I'm not buying any more iShares until I see the tracking improve.
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Gus
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Post by Gus »

Here's my latest email from iShares:
There is a TSX rule between the declaration of the dividend and the ex-div date that requires for the NAV of the fund to drop on declaration date whereas the actual price will not drop until ex-div date. The declaration date is usually around the 17th, 18th of the month; therefore, there is always a period of time where NAV is different from price by an amount close to that of the distribution. This is why tracking error will always seems wide during the mismatch period. Things should get back to normal by the beginning of next month.
That seems more like it...

BTW, it helps in getting a quick response if you say that you will post the answer on an internet financial forum. :wink:
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Post by IdOp »

Barclays quoting TSX wrote:There is a TSX rule between the declaration of the dividend and the ex-div date that requires for the NAV of the fund to drop on declaration date whereas the actual price will not drop until ex-div date.
This is absolutely mind-boggling. Can anyone think of a reason why the TSX would want to make this kind of rule, or are they just ... ?
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Post by DavidR »

Norbert Schlenker wrote:Honestly, I think it's an accounting problem. AFAIK the distribution is not legally a liability until the record date (the ex-div date if you're actually trading) but BGI has booked it as such on the declaration date. That whacks the NAV.).
I don't know about it 'legally' being a liability - perhaps the directors could 'cancel' it before the payable date if they changed their minds? But has such a thing ever ever happened?

But under GAAP it would be a liability as of the declaration date for sure. [For example, YLO.UN usually makes its distribution payable on the 15th of the month, yet shows a liability in its quarterly financial statements for the amount declared but not yet paid...]
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Post by Norbert Schlenker »

DavidR wrote:But has such a thing ever ever happened?
http://www.businessweek.com/ap/financia ... PVRJ81.htm
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Post by DavidR »

IdOp wrote:
Barclays quoting TSX wrote:There is a TSX rule between the declaration of the dividend and the ex-div date that requires for the NAV of the fund to drop on declaration date whereas the actual price will not drop until ex-div date.
This is absolutely mind-boggling. Can anyone think of a reason why the TSX would want to make this kind of rule, or are they just ... ?
TSX wants them to follow GAAP regarding liabilities for dividends payable, I guess.
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Post by DavidR »

Norbert Schlenker wrote:
DavidR wrote:But has such a thing ever ever happened?
http://www.businessweek.com/ap/financia ... PVRJ81.htm
That was a fast reply! Why would the US (of all places) have a Federal law mandating an asset coverage ratio? Wouldn't that be something best negotiated between borrower and lender?
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Post by yielder »

tidal wrote:even the XGB's seem to have gapped, so let's hope it is related to distributions... but I find it disturbing as well...

and i still don't get how the XIC's and others went to such extremes on October 14...
http://www.financialwisdomforum.org/for ... p?t=109077
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Post by IdOp »

DavidR wrote:TSX wants them to follow GAAP regarding liabilities for dividends payable, I guess.
Thanks for the input. I suppose it's hard to go against GAAP even if it doesn't make much sense in a case like this. Maybe the easiest solution would be for Barclays to use a different term, such as "effective NAV" (or whatever they want to make up) to use for the more informative figure, and present their info that way.

Another question is, how did the ETF's trade during this period? If they traded above the GAAP NAV this would indicate the pros were aware of the situation (while us retail folks are left floundering in the dark).
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Post by DavidR »

IdOp wrote:Thanks for the input. I suppose it's hard to go against GAAP even if it doesn't make much sense in a case like this.

Maybe the easiest solution would be for Barclays to use a different term, such as "effective NAV" (or whatever they want to make up) to use for the more informative figure, and present their info that way.
Pro-forma numbers, eh? An equity index fund ETF would have to consider making at least one more set of adjustments, I think, to account for dividends that they are going to collect on their investment holdings - that is, dividends declared but not yet at their ex-date. (Under GAAP they are not allowed to accrue them as receivables until the ex-date, yet if they are index fund they are pretty likely to still own the shares as of the ex-date, and thus collect the dividend.)
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Post by IdOp »

DavidR wrote:An equity index fund ETF would have to consider making at least one more set of adjustments, I think, to account for dividends that they are going to collect on their investment holdings - that is, dividends declared but not yet at their ex-date. (Under GAAP they are not allowed to accrue them as receivables until the ex-date, yet if they are index fund they are pretty likely to still own the shares as of the ex-date, and thus collect the dividend.)
I'm not sure why they would have to adjust for dividends declared but not yet gone ex. ISTM in that situation the dividend is baked into the stock price already. Once it goes ex, the stock price drops (all else equal) and the unreceived dividends (essentially, a short-term corporate bond) should be accounted for. From your description GAAP gets this part "right". OTOH forcing the ETF to deduct from the NAV a potential liability (declared dividend not yet gone ex) seems inconsistent with this to me. It's kind of like saying the BCE takover was a done deal before all the conditions were met, in this case the ex-dividend date having arrived.

So the "pro forma" aspect I suggested would be to correct this inconsistency and give investors a number they can meaningfully (a) compare with an appropriate benchmark, and (b) use to guide their bid or ask prices in trades. Clearly, the situation as it stands has led to confusion and not been explained well by Barclays.
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Post by DavidR »

IdOp wrote: I'm not sure why they would have to adjust for dividends declared but not yet gone ex. ISTM in that situation the dividend is baked into the stock price already. Once it goes ex, the stock price drops (all else equal) and the unreceived dividends (essentially, a short-term corporate bond) should be accounted for. From your description GAAP gets this part "right".
Yes, I think I had forgotten the 'baking in'.
IdOp wrote: OTOH forcing the ETF to deduct from the NAV a potential liability (declared dividend not yet gone ex) seems inconsistent with this to me.
It does create a timing problem for the investor (an individual or a fund or a fund of funds), but it is GAAP for the payer: the Directors/Trustees have committed the entity to making the dividend/distribution payment. It would be misleading not to accrue the liability. Unless of course there should be a different GAAP for ETFs than for all other entities...but how can we argue that YLO should accrue its distribution payable but a Barclay's ETF should not? Of course the situations are not identical: With YLO, balance sheets are available for investor scrutiny only quarterly, yet an ETF is expected to release an accurate NAV daily.. The 'pro-forma' solution might indeed be is the best one - give the investors what they need without undermining GAAP.
IdOp wrote:It's kind of like saying the BCE takover was a done deal before all the conditions were met, in this case the ex-dividend date having arrived.
Not the same thing at all IMO.
IdOp wrote:So the "pro forma" aspect I suggested would be to correct this inconsistency and give investors a number they can meaningfully (a) compare with an appropriate benchmark, and (b) use to guide their bid or ask prices in trades. Clearly, the situation as it stands has led to confusion and not been explained well by Barclays.
Agreed.
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Post by IdOp »

DavidR, I think I see a bit better now what you mean regarding the Payer, at least in practice. As always thank you for the interesting, enlightening comments.
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Post by DavidR »

Thanks for the kind words IdOp. I always find your posts thoughtful and your positions well-argued. Happy new year to all!
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Post by Norbert Schlenker »

Anyone still interested in the tracking error on the BGI bond funds? If so, you might want to look at the tracking error charts on their website. Lo and behold, it appears (now) that there was no tracking error in the second half of December.

Does that make you more or less disturbed than you were two weeks ago?
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Post by Peculiar_Investor »

Just finishing checking the tracking error for iShares XIN :x the hedged EAFE ETF.

Period 07/01/2008 to 07/01/2009

Annualized performance difference
2.20% *

Fund return -39.26%
Index return -37.05%
Expense ratio 0.49%

Ouch!

So today in my RRSP, sold XIN, bought VEA (Vanguard). MER on VEA last year was 0.12% :) What about tracking error you ask? Well from https://personal.vanguard.com/us/funds/ ... IntExt=INT, as of 12/31/08,

Europe Pacific ETF Market Price –40.57%
MSCI EAFE Index -43.38
Performance difference 2.81% * :)

* Note to Barclay's. You cannot fool me, the Annualized performance difference is -2.2%.
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Post by Gus »

Peculiar_Investor wrote:Just finishing checking the tracking error for iShares XIN :x the hedged EAFE ETF.

Period 07/01/2008 to 07/01/2009

Annualized performance difference
2.20% *

Fund return -39.26%
Index return -37.05%
Expense ratio 0.49%

Ouch!
It seems that the tracking error is on the Canadian side of the iShares EAFE finds since the US equivalent iShares fund shows very little tracking error. The XIN tracking error may be due to currency hedging errors.

OTOH, I am not sure how the indices handle withholding taxes on non-domestic equity fund income. Perhaps that is another source of tracking error and it may depend on which country's accounting rules are used to determine NAVs.
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Post by Shakespeare »

The XIN tracking error may be due to currency hedging errors.
They aren't necessarily "errors": IIRC, posted on some thread in this forum, is the info that XIN hedges each currency individually. So a "tracking error" wrt EFA hedged only to C$, is to be expected.
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Post by Bylo Selhi »

Peculiar_Investor wrote:MER on VEA last year was 0.12% :) What about tracking error you ask? Well from https://personal.vanguard.com/us/funds/ ... IntExt=INT, as of 12/31/08,

Europe Pacific ETF Market Price –40.57%
MSCI EAFE Index -43.38
Performance difference 2.81%
A caveat. VEA is a share class of the Vanguard Tax-Managed International Fund, whose Primary Investment Strategies reads:
The Fund purchases stocks included in the Morgan Stanley Capital International Europe, Australasia, Far East (MSCI EAFE) Index, which is made up of approximately 1,211 common stocks of companies located in 21 countries in Europe, Australia, Asia, and the Far East. The Fund uses statistical methods to “sample” the Index, aiming to closely track its investment performance while limiting investments in Index securities that have undesirable tax characteristics in an attempt to minimize taxable income distributions.
So, while they try to track EAFE, they're willing to bend their principles in the name of tax-efficiency. That's probably good news for Canadians since unlike US residents we have to pay full freight on taxes on distributions and we can't recover taxes withheld by constituent countries in the index, but it also means that the tracking error could deviate in the other direction. You probably shouldn't worry about that too much because generally Vanguard's tracking errors are less than the MER. All that for a razor thin 12bp.

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Post by DenisD »

Vanguard wins one and loses one in 2008.

Code: Select all

Symbol     Return
VEA        -41.25
EFA        -43.14
VWO        -52.77
EEM        -50.01
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Post by adrian2 »

DenisD wrote:Vanguard wins one and loses one in 2008.
AFAIK, VWO and EEM track different indices (both emerging markets, with different countries included and / or weights).
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