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THE INVESTMENT PERFORMANCE AND TRACKING ERRORS OF SMALL-CAP ETFs

Zakri Bello1

Central Connecticut State University, USA.

 

ABSTRACT

ETFs and index mutual funds are similar and are considered as substitute products. However, ETFs are listed on an exchange, are traded throughout the day, and are generally assumed to have lower tracking errors than index mutual funds. Furthermore, ETFs have lower expenses and are more tax efficient.

This study investigates the tracking errors and investment performance of small-cap ETFs that tracked the Russell 2000 index, and compares the results with those of index mutual funds that tracked the same index. The results show that ETFs are on average larger in the size of assets, they have lower expense ratios, and they have higher portfolio turnover. Moreover, ETFs generally have lower portfolio holdings and they invest a greater percentage of their portfolio funds in the top-ten companies they hold. This suggests that ETFs are less diversified than index mutual funds.

Also, the two types of funds underperformed the Russell 2000 index as indicated by both the Jensenís alpha and by the Sharpe information ratio. Jensenís alpha indicates that index mutual funds outperformed the ETFs, and Sharpe information ratio indicates that ETFs outperformed the index mutual funds. This latter finding is more realistic because previous studies have documented that mutual fund portfolios contain significant idiosyncratic risks. Surprisingly, the results also indicate that ETFs have larger tracking errors than index mutual funds irrespective of the two methodologies used.

Keywords: Exchange Traded Funds, ETF Tracking Errors, Index Mutual Funds, Investment Performance, Portfolio Selection, Fund Size.

JEL Codes: C12, C13, C18, C33, G11, G12, G23, N20.