Remember what Obi-Wan Kenobi told a group of stormtroopers as they inquired about Luke Skywalker’s droids? These aren’t the droids you’re looking for. Obi-Wan may have used a Jedi mind trick to fool those stormtroopers, but when it comes to investors who analyze net asset value (NAV) performance to measure the tracking error exhibited by Vanguard international ETFs, I would suggest (no fooling) that those aren’t the returns you’re looking for.

I understand the concern. The existence of what is perceived as high tracking error would seem at odds with funds that are run at cost and managed with a large percentage of index replication. While costs and optimization¹ can cause a fund’s return to deviate from that of its benchmark index, the practice of fair-value pricing can be an influential driver of deviation for certain Vanguard ETFs®.

Some fund NAVs—and stock index values—are calculated using the closing prices of underlying securities in their local markets. However, many local markets close before the U.S. markets, so by the time an international stock fund in the United States strikes its 4 p.m., Eastern time, NAV, the local prices of international stocks are stale.

Price-affecting information continues to enter the marketplace, but such information does not have an effect on those stocks because the markets on which they trade are closed. Fair-value pricing estimates what international stocks would be worth if their local markets were still open for trading alongside U.S. markets.

Let’s use a hypothetical example to illustrate.

Suppose ABC Inc., an Asian computer manufacturer, ended its trading at 1 a.m., Eastern time, at $50. That’s the price that indexes use. When funds also use that same price, there is no resulting tracking error.

Now suppose that during the U.S. trading day, the shares of personal computer makers are trading flat until news hits that global demand for PCs is going to severely fall, and, as a result, the shares of several well-known PC makers in the United States suddenly drop 5%.

If Asian markets were open, it’s reasonable to assume that the price for ABC stock would also drop.
Vanguard’s process for fair-value pricing uses unbiased input such as statistical models and other market data that, in this hypothetical case, would likely price ABC in its international portfolios closer to $47.50 than $50.

Same stock. Different Price. Tracking error?

Vanguard does this because we provide our mutual fund investors with the opportunity to buy and sell shares at a 4 p.m. NAV. The fair-value pricing discourages market-timing in our mutual funds, which benefits our long-term shareholders as the actions of market-timers can drive up costs for other shareholders.

So why does this affect Vanguard ETFs?

Since Vanguard ETFs are a share class alongside mutual fund share classes of the same fund portfolio,
their NAVs are computed via the same process. ETFs obviously provide investors with intraday market
price (not NAV) liquidity because they trade on an exchange.

When attempting to gauge the performance of a Vanguard international stock ETF versus its benchmark, there are two ways to reconcile the fair-value pricing. The first looks at the fund’s NAV returns minus the fair value component, while the second looks at market-price returns. Each can be seen on a product’s performance page on our website.

Take a look at the performance table below for Vanguard Total International Stock ETF (VXUS). For the one-year period ended December 31, 2014, VXUS (-4.17% return) underperformed its benchmark (- 3.39% return) on an NAV basis by 78 basis points.

On the surface, this seems like a rather staggering amount. However, if you look at the bottom row, you can see that 65 basis points of the underperformance was due to the fair-value pricing adjustment. This means that on a pre–fair-value basis, VXUS returned -3.52%, which lowers its relative return to just negative 13 basis points. It is extremely important to note that fair-value adjustments can move in the other direction and that pre–fair-value excess returns can be positive. Either way, the difference due to fair-value pricing tends to smooth out over time.

VXUS performance as of December 31, 2014

Graphic 1

Note: The performance data shown represent past performance, which is not a guarantee of future results. Investment returns and principal value will fluctuate, so investors’ shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. For performance data current to the most recent month-end, visit our website at The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.


Analyzing market-price returns can provide insight into a kind of fair-value pricing that is imposed by market participants on the ETF itself (as opposed to the underlying securities). Again, since international stock markets are closed at the end of the U.S. trading day, market participants make bid and ask prices on international ETFs based upon those participants’ estimates of where the underlying securities would be trading if their markets were still open. It is not uncommon to see large “tracking error” for international ETFs on a market-price basis. In fact, when analyzing two ETFs that seek to track the same benchmark or substantially similar ones, checking market-price performance should be an important part of the due-diligence process.

The ability of an index fund to track its underlying index can summarily be judged by how much its returns deviate from that of the index. However, by simply judging NAV returns without understanding the potential effect of fair-value pricing, I would suggest that those aren’t the returns you’re looking for.

I would like to thank my colleague Joshua Hirt for his contributions to this blog.


1 Optimization: When an index fund or ETF uses sampling techniques instead of full replication in seeking to track the performance of an index. Optimization is often used when full replication is not practical, but it can lead to greater tracking error.


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