An Analysis of Exchange Traded Funds: Performance and Competition

Abstract

We study the universe of exchange traded funds (ETFs) from their inception to the end of 2005. Domestic equity and fixed income ETFs trade at prices very close to their net asset values. Although international equity ETFs often trade at premiums, predictable reversals are not exploitable. Almost 80 percent of ETFs are not redundant securities; they cannot be replicated with existing retail or institutional index funds. These ETFs underperform the indices that they track by over 0.6 percent per year. In contrast, the performance of ETFs that compete directly with existing index funds is significantly better than retail index funds but statistically indistinguishable from institutional index funds. We find that the introduction of competing ETFs significantly reduces flows to index funds and that new ETF entry also reduces demand for incumbent ETFs in the same investment style.