What are we looking for?
The best performers among broad-based Canadian stock and bond exchange-traded funds.
Out-indexing the indexes
Canadians' fondness for ETFs – especially the big, broadly based ones – stems from the fact that they are a low-cost way to buy the performance of an entire well-diversified stock or bond index. Because these funds mimic the composition of the indexes, the idea is that investors in such an ETF will mimic the returns of the entire index.
But it turns out that ETFs don't precisely replicate the returns of the indexes they track. Because the managers of an ETF incur transaction costs when making small adjustments to the fund to match index changes, and because the units of the ETFs themselves actively trade in the market, small discrepancies can arise between the returns generated by a fund and those produced by the index it tracks. The ability to limit and smooth these little discrepancies speaks to how efficiently an ETF is managed.
National Bank Financial – which has made something of a specialty of researching the ETF sector – issues a quarterly report showing how well Canada's big, broad-based equity and bond ETFs are performing relative to their benchmarks. Its second-quarter report came out last week.
What did we find?
NBF analyst Pat Chiefalo said the "perfect" ETF would exactly match the index it tracks, but he acknowledges that we don't live in a perfect world, and there are transaction costs that are inevitable in ETFs. About the best we can look for, he said, is an ETF whose underperformance relative to index returns is in line with the fund's management expense ratio (MER). He added that volatility, or "tracking errors" (the deviation the fund's returns have from the index returns, regardless of whether they are higher or lower) should also be kept to a minimum, as they speak to the smoothness and predictability of the returns.
"Outperformance really is not desirable, because it indicates that something else is going on," he said – such as tweaking of the fund by its managers that may result in uneven and inconsistent performance relative to the index.
Mr. Chiefalo noted that the Horizon S&P/TSX 60 ETF, which tracks the blue-chip Canadian stock index of the same name, "continues to perform exceptionally well." Its average weekly underperformance of the index was a mere 0.08 per cent on an annualized basis, in line with its MER. It shows little or no volatility, and the price of the ETF units are in line with their underlying net asset value.
Notes: Period Return is based on net asset value (NAV) with reinvested dividends. Excess Return is total return minus total benchmark index return. Mean Excess Return is average weekly total return minus total benchmark index return, annualized. Tracking Error (Volatility) is the standard deviation of weekly returns less benchmark index returns. Premium to NAV is average end-of-day price premium to adjusted net asset value. Source: National Bank Financial
David Parkinson