The Myth of Positive Excess Return of Etfs in China : Decomposition and Attribution of ETF Tracking Errors

This study uses a sample of 72 passively managed equity exchange-traded funds (ETFs) from the Chinese A-share market to examine the size and time-varying characteristics of their tracking errors, identify their determinants, and gain insight into the persistent and positive excess returns of China’s equity ETFs. We find that ETFs’ net asset value (NAV) traces its indices precisely on a daily basis, yet the NAV and index return differences are positive for most trading days. There are larger deviations in ETF closing prices from the indices than those of NAV from the indices, and the tracking errors of the delisted ETFs are significantly larger than those of the surviving ETFs. Our regressions show that the index volatility, cash drag, and ETFs’ transaction costs positively correlate with NAV-index tracking errors, whereas the leverage ratio is negatively correlated. However, closing price tracking errors are mainly affected by market factors, including the liquidity and volatility of the underlying securities and the liquidity of the ETF itself. Dividing the study period into bull and bear markets, we present that it is more difficult for ETFs to track the benchmark in bearish markets, when the tracking capabilities across ETFs are more dispersed. Additionally, most of the determinants have an asymmetric influence on tracking errors in bull and bear markets. We further decompose the NAV-index tracking errors into three parts based on the capital asset pricing model (CAPM) to analyze the reasons for the ETFs’ excess yields. The results indicate that initial returns of initial public offerings (IPOs) are important for ETFs’ positive absolute returns. It proves that the capability of China’s ETF managers to outperform the market may not necessarily be greater than that of managers in other markets, as part of the excess return comes from market inefficiencies. Specifically, the market rules grant ETFs the right to profit over ordinary investors