Tracking Errors and Their Determinants Evidence from Japan-listed exchange-traded funds

Abstract

The purposes of this study are to compare the tracking error between 53 sampled physical and 15 over-the-counter (OTC) swap-type exchange-traded funds (ETFs) on the Tokyo Stock Exchange, and to contribute to a better understanding of the impact of selected determinants on the daily tracking error. The sample synthetic ETFs are found having higher tracking error than the sampled physical ETFs. The synthetic-type ETF managers may be difficult in using derivatives to replicate the benchmark performance. A panel regression model with cross-section fixed effects indicates the tracking error of the sampled physical ETFs is negatively related to size but positively related to expense ratio, dividend yield, trading volumes, market risk, and number of constituents in the target indexes. The results conform with the hypotheses that the expense, delay in receiving dividends, the trading cost and the market risk may erode the tracking ability; on the other hand, the economies of scale will improve the tracking ability. This study may help to raise a broader discussion of potential tracking error determinants and to provide some new insights.