Last week I shared my interview with Timothy Nash, president of Strategic Sustainable Investments, the blogger behind The Sustainable Economist, and an expert in socially responsible investing (SRI). This week I’d like to profile a number of investment products that may be appropriate for Couch Potato investors who are interested in SRI.

I’m not endorsing any of these investments: I don’t use any of them myself, and although I’ve made an effort to understand what they have to offer, I haven’t performed any due diligence on them. You’re responsible for thoroughly checking out any investment before adding it to your portfolio.

Canadian equities

The iShares Jantzi Social Index Fund (XEN), launched in 2007, tracks the best-known SRI benchmark in Canada. The Jantzi Social Index excludes companies involved in military contracting, nuclear power and tobacco, as well those involved in “significant controversies” such as environmental spills. The index includes 60 companies and is designed to roughly mirror the sector weights of the S&P/TSX 60. For what its worth, XEN has outperformed the iShares S&P/TSX 60 (XIU) over the five years ending in April despite is much higher fee (0.55%).

The Meritas Jantzi Social Index Fund tracks the same index, but the manager has also “added further screens in the areas of alcohol, gambling and pornography.” This mutual fund is a lot more expensive than its ETF counterpart: the A Series has an MER of 2.23% plus loads, and the F Series charges 1.30%. But it has a much more activist mandate that some SRI investors may be willing to pay for. Meritas has a long record of shareholder engagement, which the iShares ETF does not share. The fund also allocates a small share of its assets to community development investments that “foster sustainable social and economic well being.”

US equities

The US family of iShares ETFs offers two index funds for socially responsible investors. The iShares MSCI Socially Responsible ETF (DSI) holds 400 large, mid and small-cap stocks screened for “positive ESG [environmental, social and corporate governance] performance relative to their industry peers.” The index gives the boot to companies involved in “alcohol, tobacco, firearms, nuclear power, military weapons and gambling.”

The iShares MSCI Select Socially Responsible ETF (KLD) focuses on fewer and larger companies: it includes about 130 stocks with a median market cap about twice as large as that of DSI. It also screens for companies with high ESG ratings, though the only business activity specifically excluded is tobacco.

The sector breakdown in these two indexes is roughly the same as the broad market so they “exhibit risk and return characteristics similar to the MSCI USA Index.” The MER on both funds is 0.50%.

Importantly, these iShares ETFs have a clear proxy voting policy “consistent with the principle that ‘socially responsible’ shareholders are concerned not only with economic returns and sound corporate governance, but also with the ethical behavior of corporations and the social and environmental impact of their actions.”

International equities

When it comes to SRI index funds tracking companies outside North America, the pickings are slim. The only ETF that fits the bill is the Pax MSCI EAFE ESG Index ETF (EAPS). The index is designed to mirror the popular MSCI EAFE Index, so the largest country allocations are Japan and the United Kingdom, and the largest sector weights are financials, consumer retailers, and health care. From a universe of almost 1,000 stocks, the index screens for the top 150 or so with the highest ESG ratings. The ETF’s management fee is 0.55%.

“Pax World has been in this space for a very long time, and they also perform shareholder engagement, which is why I really like them,” Tim Nash told me in our interview. But this ETF very small, with just $30 million in assets. Indeed, one potential problem with SRI funds is they’re often slow to attract investors and are vulnerable to closure: Pax World used to offer a North American equity ETF with a socially responsible screen, but that fund was shuttered in March. (If a fund closes you don’t lose your money: you’re just forced to liquidate. But in a nonregistered account, a forced sale can stick you with capital gains taxes.)

Later in the week I’ll look at fixed income options for socially responsible Couch Potatoes.

Here’s part two of my conversation with Timothy Nash, president of Strategic Sustainable Investments and the blogger behind The Sustainable Economist. (Part one is available here.) Next week I’ll go into more detail about specific investment products that combine passive investing with SRI principles.

Many socially responsible investors seem to think buying a company’s stock is somehow giving them capital they can use to do evil, and that’s why they’re wary about owning index funds. I’m not sure I buy that argument.

TN: I often get asked how much of a difference I’m making by owning socially responsible index funds or ETFs. And it’s tricky, because obviously when you own equities the money doesn’t go directly to the company—at least not once you’re beyond the IPO. But you can make the argument about cost of capital. When companies have a large market cap, the more demand there is for that stock, and the easier it is for them to raise capital.

There is another argument, too. With ethical consumerism—whether you’re buying fair trade, or local, or organic—you are impacting that invisible hand of the marketplace. You’re creating demand for fair trade, or local, organic produce in the marketplace, and then you’re supporting those businesses. You can make the same argument when it comes to owning mutual funds or ETFs: by contributing, even in modest amounts, to the assets under management of these funds you are showing support for this type of investment strategy, and you are strengthening that fund.

One example might be the Meritas Jantzi Social Index Fund. Its MER is well over 2%, but Meritas has been at the forefront of shareholder engagement in Canada. Some people may be willing to pay that high fee to support their efforts. That’s different from paying for active management.

TN: Exactly. And that’s why I really like the shareholder engagement approach. Because then you are having an impact by pushing the company toward sustainability. I think we’re onto something there: it’s more about the investment philosophy you are supporting. In terms of where your management fees are going, would you prefer them to go to a manager who is socially responsible? I think that’s a valid argument, though whether it will have traction with investors is up for debate.

Meir Statman makes an interesting argument in his book, What Investors Really Want. People often say you should not spend more for socially responsible investments: instead, you should simply buy a low-cost index fund and use your savings to support your preferred charities. But Statman says for some people that’s like telling an Orthodox Jew he should save money by buying cheaper cuts of pork and donate the extra money to the synagogue.

TN: I think that’s definitely true. For most of my clients, it comes down to integrity. Many of my clients work in the non-profit sector, in social justice, or in the environment. And if you are working for an environmental organization day in and day out, and then your pension plan invests in oil sands companies, there is a gap there. Many of them do not want to put their money in any fund that holds companies they would not hold themselves. It really comes down to aligning your investments with your values.

In my latest MoneySense column (see the June issue, not available online), I explored whether socially responsible investing is compatible with the Couch Potato strategy. If you’re not familiar with SRI, it’s about finding investments compatible with your ethics, which often means avoiding so-called sin stocks and companies with poor environmental records. It may also involve selecting investments that have a positive social impact.

My main source for that column was Timothy Nash, president of Strategic Sustainable Investments, a company that helps institutions and individuals create portfolios aligned with their values. Tim also has a blog called The Sustainable Economist and recently wrote a post called The Organic Couch Potato, where he shared his ETF suggestions.

Tim is a thoughtful, articulate advocate for SRI and I thought readers would like to hear more from him, so here’s an excerpt from our interview. I’ll run another in a few days, and next week I’ll go into more detail about specific investment products that combine passive investing with SRI principles.

In many ways passive investing and SRI seem incompatible. One of the fundamental ideas behind indexing is that you don’t pick individual companies. But with SRI, that is often what you’re doing.

TN: I actually see a lot of overlap between the two strategies, primarily in the sense that both are about long-term investing.

When it comes to choosing individual companies, I don’t think that’s what socially responsible investing is about at all. There are different approaches, and by far the most popular is negative screening. This started with religious communities that would exclude “sin stocks” like tobacco, firearms, and things like that. That has evolved to the point where the majority of socially responsible funds rank every company according to a sustainability score—the lingo we use is ESG, for environmental, social and governance. So every company will get an ESG score, and then the fund will drop the bottom 20% in each sector. This is the methodology used by the Jantzi Social Index, for example, and most of the SRI funds use a similar approach to that.

In some cases, rather than just dropping the bottom 20% they will have black list: if there has been a controversy, they will exclude that company. For example, Enbridge is excluded from the Jantzi Social Index because of the big oil spill that happened in Michigan in 2010. BP is another classic example: in fact, that company was in a number of SRI portfolios before the Deepwater Horizon oil spill, but as soon as that happened it was excluded.

Another strategy, which is important to many passive investors, is shareholder engagement. With traditional mutual funds you don’t go to the shareholder meetings yourself: you’ve got proxies, and the default policy is to simply vote with management. Let’s say there’s a shareholder resolution that would require the company to report their carbon emissions, and management says that’s a burden. Traditional investors will have their votes go with management against the resolution. Whereas with socially responsible investments, if they do shareholder engagement your vote will be used to push that company toward greater transparency, greater disclosure, greater sustainability.

Not all index funds do shareholder engagement: the iShares Jantzi Social Index Fund (XEN) doesn’t do it, but the US-listed iShares SRI funds do [These are the iShares MSCI Socially Responsible (DSI) and iShares MSCI Select Socially Responsible (KLD).] I’m really shocked the Canadian one doesn’t, because they are all iShares, and it’s all the same company, but the two funds in the US have a voting policy statement that says they will vote for any measure that promotes transparency and sustainability. I can’t tell you why the Canadian Jantzi ETF doesn’t.

What other strategies are used by SRI index funds?

TN: Another strategy is positive screening. With negative screening you get rid of stuff you don’t want: the worst of the worst. Positive screening is about including companies in sectors you do want. For passive investors there are a number of ETFs that follow what I would call green themes. There is a solar ETF, a wind ETF, and also a couple of water ETFs—as we move forward in a world that is experiencing climate change, I think water is going to become a huge issue. The one I put in my own Couch Potato portfolio is the PowerShares Cleantech Portfolio (PZD), which is diversified across a number of green themes.

The last strategy is called impact investing. This is a really hot topic right now in certain circles, but it hasn’t really made it into the mainstream yet. Impact investing involves going outside of financial markets and investing directly in projects that have both a positive financial return and a positive social or environmental impact.

One example is microcredit financing: that has been around for the longest. Another is community bonds, which are usually are centered around non-profit real estate. There’s a website called socialfinance.ca that follows a lot of these trends. They’re still very new and there aren’t many available, but it’s a very cool option for socially responsible investors because instead of SRI meaning you’re not going to invest in tobacco, military, and firearms, this is a way for investors to have direct impact and generate a financial return.

This post is excerpted from The DIY Investor’s Handbook, coauthored by myself and Justin Bender, and available exclusively to clients of our DIY Investor Service.

Occasionally when you buy an ETF you won’t be eligible to receive the fund’s next dividend payment. At other times you’ll sell an ETF only to be paid a dividend a few days later. This is confusing for many investors, so let’s look at some important dates surrounding dividend payouts.

When a fund announces a dividend (or other distribution, such as an interest payment from a bond ETF), it will declare a record date and a payment date. For example, it might announce it will pay a distribution of $0.10/share to investors who own the ETF on January 15 (the record date), with the payment to be made on January 18 (payment date). In this case, if you sell your shares on January 16, you will still receive the dividend two days later, even though you no longer own the fund.

Two business days before the record date, the ETF will begin trading ex-dividend (“without dividend”). This means if you purchase the ETF on this date or later, you will not receive the upcoming dividend. For this reason the ETF’s net asset value—and therefore its price—will drop by the amount of the distribution on the ex-dividend date. However, if you sell the ETF on the ex-dividend date or later, you will still receive the distribution, because you will still be considered the shareholder of record until the trade settles three business days later.

Until the ex-dividend date, the ETF is said to be trading cum dividend (“with dividend”). The last cum dividend date is always three business days before the record date: the ETF purchase will therefore settle on the record date. However, if you sell the ETF on the cum dividend date, you will not receive the distribution, because you will no longer be considered the shareholder of record when the trade settles three business days later.

Using our example above, here’s how these dividend dates affect whether you’ll receive a distribution after buying or selling an ETF:

A couple of important points to consider:

• If you’re planning to buy an ETF in your taxable account near year-end, it may be wise to wait until it is trading ex-dividend. This way you’ll avoid the dividend and the taxes that come with it. You’re not losing out by doing this: remember, the ETF will fall in price on the ex-dividend date to compensate you for not receiving the distribution.

• If you have a dividend reinvestment plan (DRIP) with an ETF and you’re planning to sell your entire holding, do so while it is trading cum dividend. If you don’t, you may get stuck with a few extra shares of an ETF you thought you were rid of, because you’ll receive the distribution in the form of new units rather than cash. That could mean another trade to clean up the account.

Franklin Templeton recently released its 2013 Global Investor Sentiment Survey, which polled 9,518 people from 19 countries. The survey found that 81% of Canadian investors “expressed optimism about reaching their financial goals.” However, many of the other results suggest this optimism may be misplaced.

I want to stress this wasn’t a random survey conducted on street corners, where you would expect some respondents to be oblivious teenagers or people without money to invest. All of them were at least 25 years old and owned a significant amount of stocks, bonds or mutual funds, ensuring they had “a knowledge base from which to answer the survey questions.”

Here’s the first head-slapper: 52% of Canadians in the survey believed the stock market declined or was flat in 2012. In fact, the S&P/TSX Composite was up 7.2% last year. That’s a remarkable lack of awareness that shows how many investors still refuse to believe we’ve been enjoying a bull market for more than four years. Even more amazing, almost a third of US investors also said the market was flat or down in 2012, despite a rip-roaring 16% return for the S&P 500.

Given these misperceptions, it should come as little surprise that many Canadians have soured on stocks. More than half (56%) reported they can meet their investment goals without equities in their portfolio. That swelled to more two-thirds (68%) for those aged 25 to 34, meaning younger Canadians are the most conservative of all age groups. This younger crowd also seems the most pessimistic: only 13% said they expected stocks to outperform other asset classes in 2013, and 59% said they were planning to make their investments more conservative this year.

If this survey is truly representative of Canadian investors, it’s a worrisome combination of overconfidence, ignorance and fear.  There’s nothing wrong with being conservative: indeed, if you’re able to meet your financial goals without taking equity risk, you should probably do so. But that choice needs to be based on accurate information, and if you think stocks went down last year you shouldn’t be making your own financial decisions. If you’re in your 30s and expect to build a retirement nest egg with no equities, you’d better do the math assuming a 2% or 3% return on fixed income investments for the foreseeable future. You might learn you’ll need to save 20% or 25% of your income.

Meet Dan Solin in Ottawa

PWL Capital’s Ottawa office is playing host to financial author Dan Solin on Tuesday, May 28, and they have invited up to five Canadian Couch Potato readers to attend. Solin is the author of The Smartest Portfolio You’ll Ever Own (see my review here) and several other books advocating passive investing. His lunch-hour talk is entitled “Seeking Alpha and Getting Clobbered.”

[Update: This event is now full.]

By now every serious investor understands the consequences rising interest rates will have on bond portfolios. For more than four years we’ve been reminded that when rates go up, bond prices fall—and the longer a bond fund’s duration, the greater the losses will be.

The conventional wisdom is to keep your bond duration short if you expect rates to rise. The problem is, the iShares DEX Short Term Bond (XSB) has a yield to maturity of just 1.38% these days—once you deduct fees, that’s less than a savings account at an online bank. And unlike a savings account (which effectively has a duration of zero), short-term bonds will still lose value if rates move higher.

It should come as no surprise that the financial industry has come up with a product that tries to address this issue: it’s called the floating-rate note. A “floater” has a maturity date like a conventional bond, but its coupon is tied to a benchmark such as the Canadian Dealer Offered Rate (or CDOR, which is this country’s version of LIBOR). The coupon is adjusted every month or every quarter.

Because of this reset, floaters have a duration close to zero and won’t lose value if rates rise—indeed, they will benefit by paying higher coupons almost immediately. The iShares DEX Floating Rate Note (XFR) boasts a duration of just 0.13, yet its yield to maturity is 1.26%, just 12 basis points lower than that of XSB. Last year, as short-term rates ticked up slightly, XFR returned 1.90%, significantly more than both short-term bonds and cash.

Whatever floats your note

So what’s the catch? Why bother with short-term bonds or savings accounts when you can get higher yields and virtually no interest rate risk with floaters? As with any investment, there are always trade-offs to consider.

The first is that floaters will underperform if short-term rates decline or stay flat. While rates have been poised to rise for a long time, the fact is the CDOR has barely budged since October 2010. More important, during a period of turmoil in the equity markets, rates are likely to fall as investors rush to safety, so high-quality conventional bonds are a better diversifier in a balanced portfolio. In 2008, XSB returned over 8%, providing a soft cushion as stock markets plummeted. Floaters could not have offered that kind of protection.

The second potential pitfall with floaters is credit risk. The good news is this doesn’t seem to be an issue with XFR, which is about 85% government bonds: more than half the holdings are rated AAA, and nothing is rated lower than A. When we next experience a panic in the stock market, these high-quality bonds are not likely to see a significant decline in value.

But that’s not true of actively managed funds, which may hold floaters that are nothing more than junk bonds. The BMO Floating Rate Income Fund, for example, lost more than 48% in 2008 as high-yield bonds cratered along with stocks and real estate. The Trimark Floating Rate Income Fund also took a 28% haircut that year. Clearly these funds are not a substitute for short-term investment-grade bonds or cash.

The only other ETF in this asset class is the Horizons Active Floating Rate Bond (HFR), which falls between the two extremes. It’s exposure (through an interest rate swap) is to corporate bonds, but they’re all investment-grade, with about 70% rated A or higher. A fund with this exposure can certainly lose money during a 2008-type crisis, but it won’t suffer anything like the carnage we saw with junk bonds. I would consider this ETF an alternative to something like the Vanguard Canadian Short-Term Corporate Bond (VSC).

In my view, floating-rate notes are little more than a tactical bet on where interest rates are headed, which is inconsistent with a passive investing strategy. For long-term investors, a traditional bond allocation (whether it’s a ladder or a broad-based ETF) will provide more protection when equity markets take a tumble, and that’s the most important role of fixed income in a portfolio. And for those who need to park cash for short-term needs, a high-interest savings account is a far safer alternative.

Carl Richards, author of The Behavior Gap, wrote an insightful article in February called Why We Fear Simple Money Solutions. “People say they want things to be simpler—investing, life insurance, retirement planning, etc.,” he observed. “But when a simpler (and effective) option is proposed, they reject it as too simple.”

I recently came face to face with this idea when working with a client of PWL Capital’s DIY Investor Service. Barbara had a portfolio of dozens of stocks and ETFs that followed no rhyme or reason. She admitted she enjoyed making trades and was inclined to buy simply buy stocks she had read about in the media. There were some blue-chip dividend payers, a couple of precious metal ETFs, plus a few random penny stocks thrown in for good measure. In other words, the portfolio was a complicated mess.

To Barbara’s credit, she realized this sort of seat-of-the-pants strategy wasn’t working: with about half a million in her RRSP and retirement approaching quickly, she knew she needed a more disciplined plan. That’s why she came to us.

After we reviewed Barbara’s spending patterns, pension income and other factors, my colleagues suggested a radically different approach. Not including the cash and GIC holdings, her new portfolio would be built from just five ETFs: one for bonds, one for real estate, and one each for Canadian, US, and international equities. The mix was in line with Barbara’s target rate of return and risk tolerance, and with the spreadsheet and instructions we provided it will be easy for her to rebalance with just a few trades per year.

Is that all there is?

We thought the new portfolio was ideal for Barbara, but when we presented it she was taken aback. Only five holdings for half a million dollars? She was clearly expecting something more “sophisticated.” You know, like those model portfolios that include a tactical position in the US health care sector, some emerging market bonds, and a 3.72% allocation to copper futures. That certainly would have looked more impressive than our simple five-ETF solution.

Fortunately it didn’t take long for Barbara to understand the benefits of simplicity. She had already admitted she’d come to us with no strategy, no long-term plan, and no attention to risk. She had also made it clear she didn’t want to work with an advisor on an ongoing basis. So our job was not only to come up with a sound strategy, but to ensure she could manage on her own. By helping her implement a low-cost, broadly diversified portfolio with just five moving parts, we accomplished those tasks.

And here’s the important point: though we streamlined Barbara’s portfolio from about 50 holdings to just five, we made it less risky. Investors who are used to building a portfolio stock by stock often struggle with this idea. They fail to appreciate that even 30 or 40 individual companies provide less diversification than one broad-market index fund. The equity ETFs we recommended for Barbara include more than 10,000 stocks from around the world.

Our investing brain seems hard-wired to resist straightforward solutions. As Richards writes, “By default, if it’s simple, say only two steps instead of ten, we think we’re missing out.” We need to get past the idea that complex portfolios increase our chances of investing success. In reality, the opposite is more likely to be true.

In Monday’s post, I reviewed the major factors that contribute to an index fund’s tracking error. Here are some other things to consider when you’re comparing your fund’s performance to that of its benchmark. These can cause tracking errors to seem unusually large or small, but they need to be understood in context.

Changes to the index. A number of ETFs changed their benchmark index during 2012, including some core equity funds from BMO and Vanguard. When there is an index change in the middle of the year, measuring tracking error becomes difficult and the numbers can be misleading. Until late September, the BMO S&P 500 Hedged to CAD (ZUE) held just 100 large-cap stocks selected using a different methodology. ZUE ended up lagging the S&P 500 by less than its management fee, which is normally an excellent result, but in this case it was a fluke.

A small number of ETFs in Canada are not tied to any third-party benchmark. The BMO Canadian Dividend (ZDV), for example, includes 30 stocks selected using an in-house methodology. In cases like this, there’s not much you can do other than compare the fund’s performance to other Canadian dividend ETFs, or perhaps to a broad market index such as the S&P/TSX Composite. Even then, this will only be meaningful over multi-year periods.

Differences between market price and NAV. Last month I explained how an ETF’s market price can differ from its net asset value (NAV). In most cases, tracking error is measured by comparing the index return to the fund’s NAV. But things get complicated when a Canadian ETF holds an underlying US-listed ETF, a structure that’s common at iShares and Vanguard. Now you’ve got two different ETFs with two different NAVs and two different market prices.

Most of the large tracking error in the Vanguard MSCI U.S. Broad Market (VUS) was likely the result of currency hedging, but its annual report also cites “differences between the market price and net asset value of the underlying US domiciled Vanguard funds in which the ETF invests.” Don’t be concerned about this sort of tracking error: it’s a short-term anomaly that would disappear if you used different start and end dates.

Fair value pricing. One of the reasons an international equity ETF’s market price and NAV can diverge is time zone differences, as I explained in a recent post. This same phenomenon can also cause the ETF’s tracking error to appear unusually large, something I first wrote about back in 2010. Vanguard uses a technique called fair value pricing to correct for some of these distortions, and this idea is described in the most recent annual report for its emerging markets ETF (VEE):

The ETF’s management fees subtracted 0.54 percentage points from the fund’s performance. Other factors, such as security selection and fair-value pricing, added back 0.46 percentage points. Fair-value pricing is a policy intended to address pricing discrepancies that may arise because of time-zone differences among global stock markets. This policy ensures that the ETF’s net asset value doesn’t include “stale” prices from markets that close before the U.S. stock market.

The key point here is that if your ETF happened to show a large tracking error recently, that’s not necessarily a reason to abandon it. It’s critical to check the fund’s Management Report of Fund Performance to determine the explanation. As with so many investing decisions, tracking error should be considered with a focus on the long-term.

Last week I explained the importance of monitoring an ETF’s tracking error, which is the difference between a fund’s actual performance and the returns of its index.

The most significant reason index funds lag their benchmarks is the impact of management fees and GST/HST. If your index fund has an MER of 0.25%, you should expect its tracking error to be within a basis point or two of that figure. But it’s often more than that—and sometimes it’s much less. In a series of two posts this week, I’ll look at some real examples from 2012 to illustrate the other factors that can cause an ETF’s returns to vary.

Currency hedging. US and international equity ETFs hedge currency risk using futures contracts. These are renewed every month, and if there’s a dramatic currency movement between contracts—or if the fund experiences a large cash inflow or outflow—that can show up as tracking error. The iShares S&P 500 (XSP) and Vanguard MSCI U.S. Broad Market (VUS) both had tracking errors over 70 basis points in 2012, despite MERs of just 0.24% and 0.17%, respectively.

Currency hedging can also work in the fund’s favour, however. That may help explain why both the iShares MSCI EAFE (XIN) and the Vanguard MSCI EAFE (VEF) outperformed their benchmark last year—indeed, XIN did so by 47 basis points. That was a lucky accident: over the long term one should expect currency hedging to cause a drag on returns because of its significant cost.

Cash drag. Most mutual funds keep cash on hand to pay investors who redeem their units. ETFs typically don’t do this, because their structure allows them to make redemptions without selling securities. But some ETFs may keep extra cash on hand, and this can lead to tracking error.

The BMO Equal Weight REITs (ZRE) trailed its benchmark by 76 basis points last year despite an MER of 0.62%. According to the fund’s annual report: “A small portion of cash was held within the portfolio to accommodate distributions. This portion of the portfolio can cause a drag on positive returns because the ETF was not fully invested. The underperformance caused by the ETF’s cash holdings was 0.14%.”

Poor sampling. Most equity ETFs hold every stock in their benchmark, even if there are thousands of them. It’s dangerous to do otherwise: several years ago, some of the old Claymore ETFs held only a representative sample of the stocks in their US and international funds and they got clobbered with enormous tracking errors.

But broad bond index funds can never do this: the major DEX indexes are enormous, and they include illiquid bonds the fund couldn’t buy even if it wanted to. These funds have no choice but to use sampling: they buy a smaller number of bonds that approximate the overall characteristics of the index (average term, coupon, duration, etc.).

You’re likely to see the biggest sampling errors with corporate bond funds. The iShares DEX All Corporate Bond (XCB) did quite well in 2012 with a tracking error of 52 basis points and an MER of 0.44%. However, since its inception in November 2006 its tracking error has been over 80 basis points.

Securities lending. A number of index funds engage in securities lending: that is, they lend stocks and bonds to short-sellers to earn extra revenue. While some critics consider this risky, when done responsibly it can actually benefit investors by offsetting some of the fund’s management fees. Normally these revenues are very small, although the iShares S&P/TSX 60 (XIU) earned almost $3 million from securities lending in 2012.

Typically funds keep some of these profits for themselves and pass along a portion to investors. (Vanguard is the exception in giving all securities lending revenue to unitholders.) In my opinion, any index fund that keeps revenue from securities lending should first ensure its tracking error is no higher than its management fee. Unfortunately, XIU lagged its benchmark by 20 basis points in 2012 even though it’s MER is just 0.18%.

Later this week I’ll look at other factors that may affect how closely an ETF tracks its benchmark index.

The ideal index fund would deliver the precise return of its benchmark, but we all know that’s not realistic. ETFs and index funds may be cheap but they’re not free, and fees almost always cause them to lag slightly. Index investors accept this because they know the alternatives are usually much worse, but they can’t be too complacent. It’s important to periodically check your ETF’s tracking error: that is, the difference between the index return and the fund’s actual performance.

Where do you find this information? Over at iShares, you simply visit the ETF’s web page and click the “Performance” tab. You’ll see the returns of both the fund and its index over various periods from one month to 10 years, as well as calendar-year returns. iShares currently lists fund returns according to net asset value (NAV) only: the market price field is blank. For example, over the 12 months ending March 31 the iShares S&P/TSX Capped Composite (XIC) lagged its index by 29 basis points:

The process is almost identical at Vanguard: again, simply visit the ETF’s web page and click the “Performance” tab. Vanguard includes returns based on both NAV and market price, so you can compare both to the benchmark. Here’s what the numbers look like for the Vanguard Canadian Aggregate Bond (VAB):

Unfortunately, BMO really drops the ball here. Using the BMO Equal Weight REITs (ZRE) as an example, you can click the Prices & Performance tab and find a link to a Tracking Error Chart, but the info is displayed only in graphical form. You can download an Excel spreadsheet with the raw data, but good luck using that to determine anything useful.

You can’t cover your tracks

Alas, no one can escape the scrutiny of a resourceful Couch Potato. That’s because every mutual fund and ETF in Canada is required to file a Management Report of Fund Performance (MRFP) twice a year. This document includes a lot of valuable information, including your fund’s recent performance in relation to its benchmark. The format is a little different for each company, but the information appears under the heading “Results of Operations.” For 2012, the fund’s MRFP reveals ZRE’s tracking error was 76 basis points:

To BMO’s credit, they make it easy to find the MRFPs for all their ETFs on a single web page. (To get there click the “Legal & Regulatory Documents” link at the bottom of any ETF page.) Vanguard also makes your job easy by including an “Annual MRFP” link on the right-hand side of every ETF’s web page. But iShares doesn’t provide a link at all. Neither does Horizons, nor the TD e-Series funds. However, you can always find your fund’s MRFP by visiting SEDAR, where companies are required to post their regulatory documents. Just key in the name of the fund and select “Management Report of Fund Performance” from the pull-down menu.

Next week I’ll share the performance results of some popular index funds, including some pleasant surprises and a few disappointments. I’ll also describe the many factors that contribute to tracking error in your portfolio.