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.

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