Exchange-traded funds, persistence in tracking errors and information dissemination

Abstract

We estimate tracking errors from 26 exchange-traded funds (ETFs) utilizing three different methods and test their relative performance using Jensen's model. We find that tracking errors are significantly different from zero and display persistence. Based on Jensen's alpha, risk adjusted returns are significantly inferior to benchmark returns for all ETFs with two exceptions at conventional significance levels revealing that passive investment strategy does not outperform market returns. We then examine the degree to which frequently used factors such as expense ratio, dividends, exchange rate and spreads of trading prices may be underlying sources of tracking errors causing this underperformance. We find that the change in the exchange rate is a significant source of tracking errors. Our serial correlation test, runs test and panel regression analysis reveal that Asian markets display relatively greater persistence and therefore are less efficient in disseminating information and noisier in filtering the information contained in returns.