An Empirical Analysis of Exchange-Traded Funds

Exchange-traded funds (ETFs) provide investors with a single, tradable security for gaining exposure to an index that presumably proxies for an asset class. In the U.S. alone, ETF assets under management have grown to nearly $900 billion. Buetow and Henderson analyze ETF returns to evaluate how closely ETF prices replicate exposures to their benchmark indices. The authors' analysis highlights practical considerations that influence index replication. On average, an ETF closely tracks its benchmark index. An ETF that tracks an index composed of less liquid securities exhibits a larger tracking error, and an ETF that tracks an index composed of less liquid, or non-U.S., securities exhibits a greater correlation (relative to the benchmark index) with a U.S. equity index, suggesting that the diversification benefits of these ETFs are less than is implied by the return properties of the benchmark index.