Q: I have an unhedged version of Vanguard’s international equity ETF (VDU), and at the end of 2014 it was lagging its benchmark by a full 1.65 percentage points. Why is this ?
A: ETFs are supposed to hug their benchmark tighter than your grandma hugged your 6-year-old self. The performance difference between an ETF and its benchmark is called the tracking error and in the example you mention, the error is significant but not surprising. Vanguard’s David Hoffman says the “differential is largely a result of fair value pricing adjustments.” This particular ETF holds securities that trade around the world, on stock exchanges that are open at different times. Fair value pricing estimates what the stocks would be worth if the U.S. markets were open, and that can be different than the actual closing value of the benchmark itself. Fair-value pricing can affect the ETF both positively and negatively in the short term, but it tends to even out over time.
Bruce Sellery is a frequent guest on financial television shows and author of Moolala. Do you have your own personal finance question? Write to us at firstname.lastname@example.org