ETF’s understanding tracking error

When it comes to purchasing ETF’s, many people assume that tracking an index is fairly straightforward.

An underlying index may rebalance quarterly while the ETF rebalances annually.  Therefore, there will be a margin of tracking error.  Furthermore, with the various countries having different rules and regulations involving buying and selling of securities, it may also be possible that imitating the index is difficult since some countries may block and/or restrict certain trades.

In some cases, the tracking error can be attributed to the fact that the ETF is actually purchasing other ETF’s and/or mutual funds.  The word is called fund of funds.  An example can be seen at http://cart.morningstar.ca/quicktakes/etf/etf_ca.aspx?t=XAL.  In the case of a fund of funds, one is being charged an MER twice.

In the end ETF’s are not perfect.  Although, I do like their low MER’s.  In any case, there maybe times when the ETF beats the index.  I am pretty sure no investor will complain about that.

http://www.theglobeandmail.com/globe-investor/investment-ideas/portfolio-strategy/watch-out-for-tracking-error-when-buying-etfs/article1759480/

Moneysense ETF tracking error at http://www.businessweek.com/magazine/content/07_11/b4025101.htm

ETFs also have a cousin called ETNs, http://www.investopedia.com/financial-edge/0213/etf-or-etn-whats-the-difference.aspx.  This is a debt note and does not pay dividends.  Being a debt note, ETNs do not pay dividends but tracks the underlying ETF with minimal tracking error.

In the screenshot above, HXT.to is an ETN while XIU.to is an ETF.  XIU.to pays dividends since it purchases the underlying stocks while the HXT.to pays no dividends since it does not own any shares in any of the companies in the index.

As for me, I like ETF’s.  They may not track an index perfectly, but at least I have a good idea what securities they are buying.

Mutual Funds, ETFs and Stocks DRIP

When it comes to collecting dividends and/or interest, investors will never see how much has accumulated over the years.  The reason is DRIP, Dividend Reinvestment Plan.  Therefore, for investors who own mutual funds, ETFs or stocks that have DRIP turned on, the interest and/or dividends will automatically be reinvested.

As a trader, I opted out of DRIP since I prefer to separate the securities I have purchased and the interest and/or dividends paid.  Furthermore, I can see more clearly if the security has gone up or down since the dividend and/or interest are deposited into my cash account.

You will see above that I have a margin and a TFSA account.  Furthermore, there is cash there.  This cash accumulates over time as the dividends and the interest are deposited when the security pays out the money.  Therefore, I can see how much I am collecting in cash from my securities which are ETFs, stocks and/or bonds.

For those who prefer to automatically reinvest the dividends and/or interest in the ETFs and/or stocks, you will have to ask your broker how it works exactly if they offer this service.

I am unsure if an investor can opt out of DRIP in mutual funds.

 

ETF or Mutual Fund Becomes Majority Owner

When it comes to ETFs, Mutual Funds or an investor with deep pockets, the problem with funds of all types in general is clear.

Once a fund buys 20% of all voting shares of a corporation, it must contact a lawyer to make sure that the fund is not breaking any Canadian securities laws.  Therefore, an ETF that tracks an index can easily overflow and takeover a company just by having too much investors money in the ETF.

The number of shares in an ETF can grow and shrink to accommodate the ETF’s demand, but the number of shares in a company cannot grow and shrink without affecting the price of the stock.  Therefore, it does not take much for an ETF to drive up the prices of all the underlying securities and own over 20% of the shares of a corporation.  After all, if money keeps pouring into an ETF, the underlying securities get bought up and less securities are available to be bought on the open market if the ETF investors are buy and hold investors.  This in turn will increase the ETF’s stake in the underlying securities.

Therefore, to avoid the ire of the various securities regulators, an ETF must either be closed to new investors or buy securities outside of the index the ETF is tracking.

Some analysts say that ETFs will blow up.  I wonder if this is what they are talking about.

I am curious on why a provider cannot just create a second or third ETF called ETF2 and ETF3 to prevent an ETF from breaking the securities regulations.  After all, an ETF’s price is the value of the underlying securities.  Furthermore, the price of ETF1, ETF2, and ETF3 can be the same since they are all tracking the same index.  They can merge or separate to not break the securities regulations.

The securities regulations must prohibit this since it could be a possible takeover loophole.

http://www.cnbc.com/2017/04/12/how-an-etf-gets-too-big-for-its-index.html

TMX’s copy of the IIROC insider trader takeover rules

Compare ETF to Main Indexes

Using morningstar.ca‘s chart, I added the following to the chart to get a better idea on how ZEB.to compares to the main indexes.  Under:

  • Enter Tickers: XSB
  • Enter Benchmarks: S&P TSX Composite
  • Enter Benchmarks: TX60
  • Enter Benchmarks: S&P 500

You will notice that the symbol ZEB.TO, when compared to the main indexes in Canada, did quite well price wise over a 5 year period.  If you compare ZEB.TO to the S&P top 500 companies in the USA, ZEB.TO did not do so well.  When you look at XSB.TO, iShares short-term bond index, it flatlined.  Therefore, minimum risk = minimum reward.

I cannot verify if the dividends or interest is factored into the indexes calculations.  Therefore, if you factor in how much dividends or interest is paid out quarterly or yearly, the return over the years can be quite different if the dividends or interest is not included into the calculations.

When it comes to comparing the return of an ETF to other ETFs or the various indexes, Morningstar.ca provides the chart tab that allows you to compare the ETF to other securities that you want to compare.  This gives you, an educated investor, a better idea on how this security performed historically compared to others.

Buy Bond ETFs on the TSX

Choosing bond ETFs is a simple process at http://www.tmxmoney.com.  You should look for bond ETFs that are the most liquid since these are the easiest to sell.  The ETF Screener is under Investor Tools under Investor Tools.

The Asset Class is Fixed Income.  The other filters can be changed to meet your criteria.

Using TMXMoney.com‘s ETF screener, you click on 3 view my list to see the list of bond ETFs available. You can sort the list with the most liquid ETF first by clicking on the liq header.  XSB.TO shows up as the most liquid.

When it comes to buying or selling, you must enter in the ticker name plus the exchange.  Therefore,

  1. The ticker symbol is XSB
  2. The exchange is TO (Toronto Stock Exchange).  The default exchange is a USA exchange if TO is not used.

To buy XSB.TO, You can either buy for $28.14/share or join the others at $28.13.  You can offer a lower buy price, but the chances of getting XSB.TO today decreases the lower your offer goes.

Always use Limit to tell the broker that you want to buy XSB.TO for a specific price only.  You can use LOC to keep the order open until you cancel which can be up to 90 days.

If you enter XSB, only the TO version is on the list.  For others where the ticker is listed in the USA exchange also, the ticker symbol will have no exchange.  For example, SU will buy Suncor on the NYSE in USD while SU.TO will buy Suncor on the TSX in CAD.  Therefore, always add .TO to every order to ensure that your buying the security on the TSX.

When it comes to buying bonds, you must understand the basic rule of the price of a bond.  When the interest rates go up, the bond price goes down.  Therefore, in an increasing interest rate environment, buying bonds is a losing money proposition.

Fortunately, the shorter the time before the bond matures, the less impact an increasing interest rate environment will have on the bond.  Therefore, if the interest rate increase by say 1%,:

  • a $100 bond that matures in 3 years may go down by $2.
  • a $100 bond that matures in 50 years may go down by $30.

The amount the price of a bond drops depends on the buyers and the sellers emotions.  There are cases where the traders do not believe the interest rate will be hiked again but drop later on, so the price of the bond may remain stable.

As a general rule, the shorter the duration of the bonds held, the less the price will fluctuate up and down.  The longer the duration of the bonds held, the more the price will fluctuate up and down.

With the last traded price of $24.90 with zero bid or sellers, it will be very difficult to buy or sell this bond for a decent price.  Fortunately, a few hours later, there are some offers.  The spread between the bid, $24.86, and ask, $25.09 is 23 cents.

There are trades being done, but very infrequently.  Therefore, VBU.TO, which is an ETF with the lowest liquidity should be avoided since it is difficult to buy and sell for a decent price.

VBU.TO has been trading since July 2014.

Using a money market ETF as a baseline, you will see that the long-term bond ETF fluctuates much more than the short-term bond ETF.  Therefore, the longer the maturity of the bond, the more volatile the bond will be.  For example, lets assume there are two bonds that are $100 each.  Furthermore, they mature in 5 and 30 years.  If the prime rate in Canada increases by 1% (100 basis points) with the fed planning on more hikes in the near future, the 5 year bond price will decrease by 1% while the 30 year bond price will decrease by 10%.  Therefore, longer terms = higher fluctuations.

The interest (coupon rate) paid out on the bonds are static.  Therefore, if the 5 year bond pays 5%/year or $5/year while the 30 year bond pays 10%/year or $10/year, the interest (coupon rate) will still be the same, but the percentage per year will be higher to reflect the drop in the bond price.  In the example above where the 5 year bond decrease by 1%, the bond price is $99 with an interest of $5/year.  The 30 year bond price is $90 with an interest of $10/year.  Therefore, the interest (coupon rate) does not change.  The percentage paid out per year changes.

When Greece was insolvent in March of 2012, and the bond investors were trying to offload their Greece Government bonds on the open market, the coupon rate was 1000%/year.  Therefore, a $1 Greece Government bond will yield $10/year.  This is assuming Greece is able to pay the interest owed.

Bond basics tutorial from Investopedia’s University

Using an ETF for Currency Conversion

When it comes to converting from CAD to USD, many of us go to the bank or the nearest foreign exchange counter.  When it comes to stock traders, we have another possibly cheaper option to convert from CAD to USD.

Horizon’s tutorial on currency conversion using ETFs

Many ETFs are traded on both sides of the border.  Therefore, a stock trader can buy an ETF in Canada on the TSX and sell the ETF in the USA on the NYSE.  By doing this, a stock trader can bypass the fee to convert CAD to USD.  The stock trader will still have to pay the broker fee and the fees the stock exchange charges, therefore, a stock trader will have to calculate if the conversion is cheaper through an ETF.

Buying Money Market ETFs on the TSX

Looking at the list of money market ETFs in Canada, there are not many available.

Horizons Medical Marijuana just came out on April 4, 2017.  Therefore, there is not enough information available.  Horizons Medical Marijuana is not a money market ETF, so it can be ignored.

Money market ETFs hold debt securities that mature in less than a year and are the most liquid, easy to sell, of all securities.  Money markets also have very minimal volatility.  Therefore, the coupon, interest rate, is minimal.

If we take a look a the Purpose High Interest Savings ETF, it invests money in several financial institutions savings accounts.  Therefore, this is an ETF that can be used to park your money in uncertain times.