EUROPEAN BOND ETFs - TRACKING ERRORS AND SOVEREIGN DEBT CRISIS

We examine tracking errors and performance of 31 European bond exchange traded funds (ETFs) during 2007-2010. On average, ETFs outperform their respective benchmarks. Our findings, contradicts recent results from international equity markets that suggest ETFs’ underperformance. The average overperformance during the sample period varies from 10 basis points to 27 basis points. Notable the over-performance is more pronounced for funds which employ physical replication. All sample ETFs have statistically significant average (mean) tracking errors at 1% level of significance. The results also suggest that that (more volatile) higher maturity segments have typically higher levels of tracking error. In particular, funds with heavy the exposure to the riskiest sovereign issuers exhibit different performance in comparison with funds that exclude the risky issuers. In the environment of widening sovereign CDS spreads and divergent yield trends, understanding selection rules of a benchmark index is, therefore, crucial for understanding fund performance.