An Evaluation of the Tracking Performance of Exchange Traded Funds (ETFs): The Case of Indian Index ETFs

Abstract

The present study investigates how efficiently India-domiciled exchange traded funds (ETFs) replicate the returns of their underlying indices and analyses the factors that determine the tracking performance. We use a three-pronged approach involving Capital Asset Pricing Model (CAPM) regression, cointegration-Vector Error Correction Model methodology and tracking errors (TEs) to assess tracking efficiency. Random-effects panel regression is employed to evaluate how fund-specific factors influence tracking ability. We find that ETFs carry significantly lower exposure towards their indices than what their objective would suggest. Long-run linkages with benchmarks exist for most ETFs, but the price deviations from the indices are fairly persistent. The TEs for the majority of the funds are large and non-trivial. Bid-ask spreads, price-net asset value deviations, fund’s age and, to some extent, its size are the primary factors that influence tracking performance. ETFs in developed markets such as the USA and Europe have been found to exhibit superior benchmarking abilities. The study is expected to assist investors in developing a more efficient ETF portfolio and to help fund providers improve the quality of their offerings.