Exchange traded funds (ETF) are one of the recent financial innovations widely viewed as significantly better investments than mutual funds given their lower fee structure and tax efficiency. Individual investors are increasingly using ETFs tracking most popular stock indices to achieve their investment goals. In some cases, investors are using these ETFs to replace index mutual funds in their long-term portfolios. Thus, it is important to compare the performance of widely held ETFs and index funds in terms of their ability to consistently track the underlying index. Another interesting research question is whether tracking errors of these two investment vehicles exhibit significant differences in the periods associated with high degree of uncertainty and volatility. Recent extreme volatility in the financial market provides a perfect setting to empirically test tracking efficiency of index ETFs and corresponding index mutual funds. In this paper we compare ETFs and Index funds performance during the period 2007-2012. This period has seen a significant increase in the ETFs both in terms of total net assets and total number of ETFs. We document a significant improvement in tracking ability of all the ETFs during the six year period. Our results suggests that for index funds perform relatively better than the corresponding ETFs in tracking large-cap and broad-market indices. In contrast, ETFs exhibit lower tracking errors compared to corresponding index funds for mid-cap indices, small-cap indices and for narrower indices tracking a segment of large-cap markets. These results support empirical and theoretical predictions in Guedj and Huang (2008). They argue that ETFs are better suited for narrower and less liquid underlying indexes. This is due to the “in kind redemption” feature of ETFs, which help them avoid flow-induced trading costs. Our results also document significant increase in tracking errors for both ETFs and index funds when market volatility is high, however their relative performance do not change. The volatility of daily returns for ETFs is lower than the volatility of daily returns of their underlying index and that of corresponding index funds during the entire sample period.
Paliwal, Rupendra, "Tracking Errors of Exchange Traded Funds and Index Funds" (2014). WCOB Working Papers. 17.