In Part 1 of this series, we examined the tracking error exhibited by the TD e-Series Canadian Bond Index Fund and the Canadian Index Fund and found that both funds track their respective benchmarks fairly well. In today’s post, we’ll look at the tracking error in the TD e-Series US Index fund and the International Index Fund.

TD e-Series US Index (TDB902)

The TD e-Series US Index Fund tracks the S&P 500 in Canadian dollars and has a MER of 0.33%. Assuming the dividend yield of S&P 500 is 2%, the withholding tax can be expected to result in a further hit of 0.3% (15% withholding tax on a 2% dividend yield). The actual tracking error of TDB902 averages 0.57% over the 2004-09 period, which is fairly close to the expected tracking error of 0.63%. However, note that the tracking error fluctuates quite a bit around the average and in some years, the fund’s returns are higher than the index.

 Year   S&P 500 (in CAD)   TDB902   Difference 
2004 2.8% 2.2% 0.6%
2005 1.5% 1.7% -0.2%
2006 16.0% 14.7% 1.1%
2007 -10.3% -11.1% 0.9%
2008 -22.6% -21.7% -1.1%
2009 9.1% 6.7% 2.2%

 

TD e-Series International Index (TDB911)

TD e-Series International Index Fund tracks the MSCI EAFE Index in Canadian Dollars. It has a MER of 0.48% but its tracking error can be expected to be higher due to the drag from withholding taxes on dividends. In 2009, TDB911 trailed the index by 4.2% but in the previous year, it returned 3.1% more than the index. On average, TDB911 has trailed the index by 0.74% over the past five years.

 Year   MSCI EAFE (in CAD)   TDB911   Difference 
2004 11.9% 10.9% 0.89%
2005 10.3% 10.2% 0.09%
2006 27.1% 25.5% 1.26%
2007 -5.0% -6.0% 1.05%
2008 -30.0% -27.9% -3.05%
2009 14.3% 9.5% 4.20%

 

Both the US Index Fund and the International Index Fund track the benchmarks fairly well over the five year period ending in 2009 but the annual returns can deviate quite a bit from the index. This is especially so for the international fund because TD Mutual Funds does not fully replicate the MSCI EAFE Index but instead uses a sampling technique to select a representative subset of stocks. ETFs such as the Vanguard Europe Pacific ETF (VEA) also employ statistical methods to sample the index. Sampling can sometimes result in quite large tracking errors in annual returns, especially in volatile markets like the ones we experienced in 2008 and 2009.

Bottom line

The tracking errors in TD e-Series Funds are not way out of line of what you’d expect when you take into account costs like MERs, withholding taxes, foreign exchange fluctuations and sampling errors. TD e-Series Funds remain a great choice for low-cost, diversified portfolios, especially when modest amounts are invested on a regular basis but the funds that track foreign stock markets can have large annual tracking errors (both positive and negative).

This article has 4 comments

  1. If I’m understanding this correctly, it is disturbing really. Time to get out a forensic accountant….

  2. Charles in Vancouver

    I wonder if the random under/overperformance could also be due to currency and dividends. For example the US index pays only an annual dividend. Over the course of a year, the underlying equities would spit out US dollar dividends that accrue until the fund is ready to drop its dividend. The actual percent dividend by the end of the year could depend on whether that accrued cash was converted to Canadian as it arrived, or only right at the end of year.

    Similarly, the index returns assume that the US dollar amount of dividends is reinvested immediately. With an annual dividend in Canadian dollars, the number of new shares bought of underlying companies will be different compared to the index expectation. This could easily create over- or underperformance.

    I see 2008 is a year when the fund did 1.1% better than the index. Notably it’s also a year in which US cash severely outperformed the stock market and the Canadian dollar. The simple fact of holding dividend cash in US$ until the end of 2008 could have easily accounted for that.

  3. So, what does this all mean? That ETFs should be used instead of these index mutual funds if one wants to track the index?

  4. Canadian Capitalist

    @Charles: Yes, foreign exchange fluctuations accounts for some of the tracking error in US ETFs / Index funds. The index returns are computed as price change plus dividends divided by the starting price. If the funds convert dividends as they are received, it will result in tracking error (both positive and negative depending on the direction of currency movement).

    @moneyxyz: Here’s the bottom line: The tracking error in TD e-Series Funds is not way out of line of what you’d expect when you take into account costs like MERs, withholding taxes, foreign exchange fluctuations and sampling errors. TD e-Series Funds remain a great choice for low-cost, diversified portfolios, especially when modest amounts are invested on a regular basis.

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