The Ins and Outs of Index Tracking

Abstract

The extent to which an index fund successfully tracks its benchmark index is gauged by two metrics: excess return and tracking error. Using a cross-sectional sample of 198 U.S.-domiciled, index exchange-traded funds (ETFs) covering 921 annual observations, the authors analyze the effect of several input variables on index funds’ excess return and tracking error. Because the sample consists of ETFs, we conduct the analysis on the basis of both net asset value (NAV) and market price. They find that a fund’s expense ratio is the dominant variable that has a significant—and negative—effect on excess return. With respect to NAV-based tracking error, they report that higher active-share levels and the existence of fair-value pricing increased tracking error. Surprisingly, the authors also find that higher expense ratios were associated with higher levels of tracking error. Finally, on a market-price basis, the effects of fair-value pricing on tracking error were greatly reduced.