The purposes of this study are to compare the tracking error between 53
sampled physical and 15 over-the-counter (OTC) swap-type exchange-traded
funds (ETFs) on the Tokyo Stock Exchange, and to contribute to a better
understanding of the impact of selected determinants on the daily tracking
error. The sample synthetic ETFs are found having higher tracking error than
the sampled physical ETFs. The synthetic-type ETF managers may be difficult
in using derivatives to replicate the benchmark performance. A panel regression
model with cross-section fixed effects indicates the tracking error of the
sampled physical ETFs is negatively related to size but positively related to
expense ratio, dividend yield, trading volumes, market risk, and number of
constituents in the target indexes. The results conform with the hypotheses that
the expense, delay in receiving dividends, the trading cost and the market risk
may erode the tracking ability; on the other hand, the economies of scale will
improve the tracking ability. This study may help to raise a broader discussion
of potential tracking error determinants and to provide new insights.