Not all index funds are created equal. Some actually track their indices pretty well, and some do a poor job. Most people think that tracking an index would be a relatively simple thing but you know what they say, “in theory, theory and practice are the same but in practice they are not.”

Some sources of index fund tracking errors:

1. Resampling (Or Optimization)

If an index has 500 constituents, then it is impractical to replicate all the holdings when the fund has a small amount of assets. For example when an index fund first starts trading, it may only buy another manufacturer’s ETF to get market Beta until there are enough assets in the fund to actually go out and buy some or all the holdings itself. The index fund manager may also choose to hold a portion of the 500 holdings until the fund gets really big (to minimize transaction costs). How do they pick which stocks to hold and which they don’t? It’s up to them, but one method is to pick a combination of stocks that allow them to replicate the GICS sector allocations in the index (Global Industry Classification Standard). That means that if financials are 20% of the index and consumer discretionaries are 20% and so on, they will pick the combination of stocks that allow them to match those numbers – in this case they are seeking to match sector Betas.

2. Cash Flow timing

When money is added to a fund it must then be deployed into the holdings. In the case of ETFs, if not enough money is added to a fund to buy a creation unit, it might sit in cash until the next day. If the underlying stocks move between the positive cash flow and the cash deployment, this could affect the index fund’s performance. In the case of a mutual fund, the portfolio manager (yes, index funds have them too actually!) might get a small cash flow and not be able to deploy it into all the underlying constituents – they may choose to buy an ETF for market or sector beta, or buy a portion of the underlying constituents and make up the difference the next trading day when new money comes in, or if money leaves the fund for a redemption.

3. Proxies

Some index funds (with foreign exposure) may buy the foreign holdings on foreign exchanges, and some may buy ADRs or GDRs (American Depositary Receipts or Global Depositary Receipts). ADRs trade in the US but may trade at a premium or discount to the actual underlying stock.

4. Market Access

Again, index funds with foreign exposure may have stocks that trade in markets that are closed when domestic markets are open and vice-versa. If the index fund buys the direct stocks, someone has to deploy the cash overnight – it can be the fund custodian who sub-contracts out to a foreign prime broker, or the fund might have an office in that market. But if the fund operates in a different market, they can only receive the money during their hours of operation, so the underlying stocks can change in value between the time the cash comes to the fund and when it gets deployed.

If the fund buys ADRs then you still have the issue of the ADR lagging the movement of the underlying stock since money gets deployed right away, but in a security (the ADR) that can itself be moved by supply-demand issues on the market it trades even though the underlying security is not being traded. Again, this can introduce tracking error.

5. Dividend Drag

This really falls into the cash flow management arena, but instead of the cash flows being due to investors adding or subtracting money from the fund, with dividend drag it is due to the receipt of dividends earned on the underlying stocks being held. The fund receives cash which has to wait to be deployed.

6. Securities Lending Income

Same principle as with dividend drag, except the positive cash flow is due to the income generated from loaning out stocks in the fund to short sellers.

7. Brokerage commissions

The fund itself has to pay commissions to buy and sell stocks, so this will create a drag on returns too.

8. MER

Ah yes, can’t forget this one! The Management Expense Ratio is made up of the Management Fee and Operating Expenses, and of course these will drag down performance of the fund as well.

Conclusion

These are some of the areas which can introduce tracking error and I haven’t even talked about currency concerns. Different index companies tracking the same indices can have dramatically different tracking errors and its certainly something that doesn’t get enough attention. Note that some of these factors may generate positive or negative tracking errors and some (i.e. fees) can only generate negative tracking error. In its purest form, tracking error is the absolute magnitude of the deviation from the index and is not normally referred to as being positive or negative, but breaking it down this way is helpful.

Related posts:

1. Does your index fund hold direct stocks or ADRs/GDRs?
2. Index Funds and the Liquidity Premium
3. Buying ADRs to Avoid Stamp Duty

Question

My question is specific to my situation obviously, but could apply to anyone in their 30s who’s changed jobs a few times and now has multiple RRSPs.

The first RRSP is a mutual fund group plan left over from my previous employer, that I still contribute to monthly, and that I borrowed 20,000 from to buy a house with 2 years ago.  It’s managed by a private investing firm here in Ottawa.  The second RRSP is a mutual fund group plan with my current employer that I also contribute to monthly (it also has a Deferred Profit Sharing Plan portion that also has a matching employer contribution).  This one is managed by Manulife but I can make changes to it online if I want.

For a few years, I was transferring all the money from my current employer RRSP to my previous employer RRSP because I thought it was better to keep one larger account growing steadily rather than having 2 separate RRSPs each of lower value.  This way I also had access to an advisor whenever I called them up, but I didn’t trust their advice since it would likely have me put all my investments with them anyway.

I hope that’s clear as mud!  What’s your take on something like this?

Answer

First a clarification – this could apply to pretty much anyone, not just people in their 30′s.

Many people will contribute to their current Group RRSP to enjoy the free company matching benefit, and once the employer contributions have vested (usually a two year period, but it can be longer or shorter) they will transfer the assets out annually to a different financial advisor/firm to enjoy greater investment options or cheaper investment options in some cases.

The rationale provided by the reader is actually a little different though – he postulated it was better to have one larger account as opposed to two. Mathematically, there won’t be any difference – all things being equal. Again, the main reason someone would annually transfer out vested contributions is to take advantage of lower costs and/or greater investment options. You will also want to keep an eye on annual account fees – not all firms have RRSP annual account fees, but some can be more than $100/year. If you have multiple accounts, each with annual fees – it can really add up.

The last statement is a bit confusing though as the reader indicates that by doing it this way he would have access to an advisor, but didn’t trust him anyways. Group RRSPs *can* offer less personalized advice, sometimes only a call centre with an occasional on-site workshop, but sometimes they are administered by “regular” advisors just like any other account. But the bigger question is the lack of trust in the advisor. Perhaps he should consider finding a more transparent advisor, or a fee-for-service advisor who works by the hour – their compensation would not be derived from product recommendations.

Hope that helps. I know there are some knowledgeable readers on this site – feel free to chime in with other suggestions or experiences.

Related posts:

1. Why Wait for your RRSP Refund?
2. Locked-In Accounts: LIRA, LRSP, LRIF, LIF, and PRIF accounts
3. Reader Question: Are MERs tax deductible?

Note: you can click on the bottom right of the video to blow it up to a full-screen view. Enjoy! Feedback welcome in the comments section below.

What Is A Mutual Fund? from Preet Banerjee on Vimeo.

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