Tracking Error and Portfolio Diversification Using Mutual Funds and ETFs

25 Pages Posted: 8 Aug 2014

See all articles by Mark Potter

Mark Potter

Babson College - Finance Division

Date Written: August 7, 2014


Current practice and research in portfolio asset allocation employs necessary assumptions about which securities and asset classes are held in particular proportions in order to arrive at an “optimal” mix of investments. These studies typically employ the average performance in the input process, yet it is unlikely that investors hold average funds, and that the specific funds they own exhibit tracking error. We find that when we examine a representative investor year, 2013, mutual funds outperformed ETFs and ETFs exhibited a greater degree of risk. ETFs had lower expenses but a greater tracking error. In addition, simulations revealed that it took twice as many ETFs to reduce tracking error compared to mutual funds. Finally, key variables that drive tracking error for both traditional mutual funds and ETFs are a manager’s experience and whether the fund employs leverage.

Keywords: mutual funds, ETFs, diversification, portfolio, risk, tracking error, investment performance

JEL Classification: G11, G24

Suggested Citation

Potter, Mark E., Tracking Error and Portfolio Diversification Using Mutual Funds and ETFs (August 7, 2014). Available at SSRN: or

Mark E. Potter (Contact Author)

Babson College - Finance Division ( email )

Tomasso Hall #120
Babson Park, MA 02457-0310
United States
781-239-6492 (Phone)
781-239-5004 (Fax)

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