There is more to index funds than meet the eye. You would think it would be relatively simple to pick a benchmark and create an index fund to track it. Just buy all the stocks in the right weightings and Bob’s your uncle, right?
Well, there is more to it than that. Benchmarks can be re-sampled and the index fund may hold less than 50% of the names in an index. The GICS sector weightings may be spot on, but the manager will only hold the biggest stocks in each sector (as an example). There is also the choice of holding the direct stocks in foreign markets on their native exchanges, or holding some type of proxy, such as an ADR (American Depositary Receipt).
For example, a manager might conclude that holding an ADR for a FTSE listed company makes sense to avoid the 0.50% stamp duty (trading tax) to buy or sell stocks as a foreigner. They may hold an ADR for Russian stocks because there is enough risk that you can’t actually get your money out of Russia when you necessarily want it. In this case, the argument for holding the ADR is for liquidity.
ADRs are subject to trading at premia and discounts to NAVs, and when cash flows are received/requested from a fund, foreign stock exchanges may not be open during local business hours. There are many trade offs in the execution of an index fund.
Luckily, if we simply look at tracking error we can avoid delving too deeply into the various issues of execution (because there are more than listed here). We can determine whether or not the manager is doing a good job by how closely he/she is tracking the benchmark over longer periods of time. The sum of the various execution trade offs will reveal themselves.
Interesting aspect. I wonder what ETFs would be most affected and by how much, approximately.
Great overview of the subject, I would be interested to find out the differing value in ADr values.
“Luckily, if we simply look at tracking error we can avoid delving too deeply into the various issues of execution (because there are more than listed here). We can determine whether or not the manager is doing a good job by how closely he/she is tracking the benchmark over longer periods of time. The sum of the various execution trade offs will reveal themselves. ”
EXACTLY!
Don’t look at the return of the index, look at the return of the ETF versus the index. Particularly look at the return of fixed-income ETFs vis-a-vis their index benchmarks – there are some real dogs in the Canadian ETF income indexing space. 50 basis points of poor trading execution is inexcusable for ETFs that are only delivering meagre yields.