Does size matter? The Effect of Assets under Management on Tracking Error in the American ETF Market.

Abstract

Numerous studies have been conducted on the subject of tracking error of mutual funds and exchange traded funds in respect to their underlying indexes. In this paper we intend to shed some light on the causes of the tracking error and more particularly if the size of assets under management of exchange traded funds have any impact on tracking error. Our working hypothesis is that there might be economies of scales that could lead to lower average expenses for the ETFs and thus lower tracking error. Trading data for a sample of 27 US ETFs during the period 2008-2013 was collected and fails to show any clear negative relationship between assets under management and tracking error. The risk variable on the other hand reveals to be positively related to tracking error for 75 percent of the ETFs and it is by far the single most important factor in explaining the tracking error.