The relative tracking ability of South African exchange traded funds and index funds

Tracking error vs tracking difference: Does it matter?

“…Gallagher and Segara (2006) found the tracking error of index funds was significantly higher than for ETFs tracking similar indices in Australia. Similar results were obtained by Blitz et al (2012) in European passive funds, while Strydom et al (2015) confirmed that South Africa ETFs exhibited lower relative risk than index funds. Overall, the recent evidence points to ETFs exhibiting lower tracking error than index funds, but whether the same is true when comparing the two types of passive funds based on tracking difference is not clear.…”

“…Thus, index funds exhibited lower relative risk than ETFs, while certain funds also had an edge over ETFs with respect to return-matching. These findings are consistent with those of Aber et al (2009) for US funds but differed from the findings for international markets such as Blitz et al (2012) for Europe and Strydom et al (2015) for South Africa. The serial correlation adjustment in the tracking error does not affect the rankings of ETFs versus index funds and the conclusions were also consistent across all measurement periods.…”

“…In light of our findings, we make important recommendations as to changes that should be made with respect to the measurement and reporting of tracking performance. Our study contributes to the growing literature on the role of fund fact sheets in investor decisions and the importance of disclosing full information to investors (Beshears et al, 2011;Ben-David et al, 2019;Darendeli, 2019;deHaan et al, 2019;Huang et al, 2020) and the extant literature on the tracking performance of passive funds (Aber et al, 2009;Rompotis, 2009;Strydom et al, 2015).…”

“…Aber et al (2019) examined tracking difference and tracking error, but differences in the performance of funds across the metrics are not closely examined. Chu (2011), Aroskar and Ogden (2012) and Strydom et al (2015) considered differences in returns based on the mean absolute deviation of Larsen and Resnick (1998); however, this approach does not capture the cumulative effects of return differences over time as is the case with tracking difference. 4.…”

“…2 Tracking error measures the volatility of the return difference between the fund and benchmark and is thus a measure of the relative risk of the fund. Empirical research has been consistent with this practice, as numerous studies have used tracking error measures to evaluate the tracking performance of index funds and ETFs (see for example, Frino & Gallagher, 2001;Jares & Lavin, 2004;Shin & Soydemir, 2010;Strydom et al, 2015). 3 A review of the fund fact sheets of the major US passive managers (Blackrock, Fidelity, Invesco, Schwab, State Street Global Advisors and Vanguard) reveals that only one (State Street Global Advisors) includes tracking error.…”