Exchange Traded Funds: Toward a Tailored Selection Approach

Abstract

The Exchange Traded Fund market is growing, and passive investors need to have reasonable grounds for choosing this investment vehicle as well as robust selection criteria. The author motivates the assertion that a tracker performance must be assessed relative to its benchmark index and not be based on absolute returns nor fund characteristics, such as expense ratio. Furthermore, the different indicators of tracking quality used in the industry, as well as some variations, are reviewed. Using examples of three major equity indices, the author argues that Exchange Traded Fund selection cannot be based on a single performance measure assessing quality common to all investors due to their various specific investment purposes and the divergent ETFs rankings according to the different indicators. Therefore, the author highlights that Exchange Traded Fund selection should be carried in an investor-specific framework founded on statistical measurements related to tracking quality relevant for each investor.

Keywords: Passive investment, ETF, tracking error, tracking difference

JEL Classification: G00, G11