Finance and Financial Management
Using daily data, we find abnormal returns associated with the ETFs are higher than the alphas of the index funds in most cases. This result is in contrast to previous results that conclude that index funds tend to have higher alphas than ETFs. The results are much more prevalent in funds that follow the S&P 500 than funds that do not. One explanation for the difference in results is the more comprehensive sample of ETFs analyzed here. When looking at the components of abnormal returns, several regressions were performed. We find that market concentration, turnover, and no load are at least marginally significant for index funds and the constant, age, expense ratio, standard deviation (risk), and market concentration are significant determinants in the abnormal returns of ETFs. When examining the tracking errors for ETFs and index funds, we find index funds are able to track their indexes much better than ETFs and domestic ETFs are better than ETFs that track indexes in other countries. The most significant finding of this paper is that tracking error affects fund flow in the following period. While fund flows are generally increasing for both ETFs and index funds, funds that track their respective index better increase their net assets by a larger percentage than funds that track their index less well.
Welch, Steven, "On Performance & Tracking Error in Exchange-Traded Funds and Index Mutual Funds" (2007). Accounting and Finance Faculty Publications. 7.