PPA’s portfolio had a trailing 12-month dividend yield of 1.61% as of Oct. 1. Therefore, PPA’s corrected tracking difference should be 0.96% - 1.61% = -0.65%. That’s precisely what we should see from a fund with a 0.64% expense ratio.
What a boring outcome. In the U.S. Aerospace & Defense area, funds’ expense ratios tell you pretty much all you need to know about their long-term holding costs. The tracking difference statistics simply highlight the importance of using total return indexes.
Don’t Dismiss The Impact Of Accounting Rules
It gets worse, and even more maddening. Sometimes fund NAVs simply don’t match the index values because of differences in their accounting rules.
This is on display dramatically in the Japan Total Market segment. The real action is in the range—the variability of tracking difference.
When we looked at the S&P 500 funds, the tracking range was a make-it-or-break-it field. Investors like predictability. Tight tracking ranges suggest that portfolio management is consistent over long periods of time.
Wide ranges mean that investors can’t know what’s coming, and that makes a body nervous. But in this case, investors can calm down, because the tracking range has been artificially inflated. Blame it on the fund accountants, or on clever fund construction.
|Ticker||Fund Name||Expense Ratio||Median Tracking Difference||Maximum Upside Tracking Difference||Maximum Downside Tracking Difference||Range|
|DBJP||Deutsche X-trackers MSCI Japan Hedged Equity ETF||0.45%||-0.55%||-0.38%||-1.16%||0.77%|
|FJP||First Trust Japan AlphaDEX Fund||0.80%||-0.63%||2.42%||-3.78%||6.21%|
|HEWJ||iShares Currency Hedged MSCI Japan ETF||0.48%||-0.72%||4.25%||-5.39%||9.64%|
|EWJ||iShares MSCI Japan ETF||0.48%||-0.28%||-0.13%||-0.53%||0.40%|
|DXJ||WisdomTree Japan Hedged Equity Fund||0.48%||-0.81%||-0.52%||-1.43%||0.91%|
Let’s look at the First Trust Japan AlphaDEX Fund (FJP) first. Overall, FJP tracks its index pretty well, trailing it by less than its expense ratio would predict. But FJP’s tracking range—varying from 2.42% on the upside to -3.78% on the downside, looks downright scary. However, there’s a story here.
First Trust, like many ETF issuers that offer both exchange-traded funds and mutual funds, has to be mindful of market timing in its mutual funds. Since the days of the mutual fund timing scandal, mutual fund accountants have been obligated to value all foreign currency positions as of 4:00 p.m. ET, when the U.S. markets close. Issuers want to use uniform calculation methods for mutual funds and ETFs, so the ETF NAVs also use a 4:00 p.m. ET currency strike.
Index providers don’t have to worry about market timing, because indexes aren’t portfolios. Index calculation agents don’t have to worry about fund accounting rules or premiums and discounts. So they follow the index industry standard, and quote their currency positions at 4:00 p.m. London time (or 10 a.m. ET). On days when the Japanese yen is volatile, this six-hour difference can push NAVs off of index levels by several percentage points. FJP’s tracking range isn’t bad. It’s just drawn that way.