Measuring Performance of Exchange-Traded Funds

Abstract

Fund selection is an important issue for investors. This topic has spawned abundant academic literature. Nonetheless, most of the time, these works concern only active management, while many investors, such as institutional investors, prefer to invest in index funds. The tools developed in the case of active management also are not suitable for evaluating the performance of these index funds. This explains why information ratios are usually used to compare the performance of passive funds. However, we show that this measure is not pertinent, especially when the tracking error volatility of the index fund is small. The objective of an exchange traded fund (ETF) is precisely to offer an investment vehicle that presents a very low tracking error compared to its benchmark. In this article, we propose a performance measure based on the value-at-risk framework, which is perfectly adapted to passive management and ETFs. Depending on three parameters (performance difference, tracking error volatility, and liquidity spread), this efficiency measure is easy to compute and may help investors in their fund selection process. We provide some examples, and show how liquidity is more of an issue for institutional investors than for retail investors.