Exchange Traded Funds (ETF) - Are ETFs a cost-efficient way for institutional investors to invest in the DAX?

ETFs vs. INDEX FUNDS - Example DAX

Master's Thesis, 2011

64 Pages, Grade: 2,0


Table of Contents

1 Abstract

2 Introduction
2.1 Hypothesis
2.2 Research Aim
2.3 Research Objectives
2.4 Rationale behind this Dissertation
2.5 Brief Background of Topic
2.5.1 What are Exchange Traded Funds?
2.5.2 Passive Management
2.5.3 What are Index Funds?
2.5.4 What is the DAX?
2.5.5 What are Institutional Investors?
2.5.6 What other alternatives are available for institutional investors for investment?
2.5.7 Brief Background on the German ETF Market

3.1 Active vs. Passive Investment Strategies
3.2 Characteristics of Exchange Traded Funds (ETFs)
3.2.1 ETFs are easy to understand
3.2.2 ETFs are transparent
3.2.3 ETFs are cost-effective
3.2.4 ETFs are secure
3.3 International Investment Market (esp. Us Markets and European Markets)
3.4 Tracking Error
3.5 ETFs tracking DAX
3.6 Mutual Funds vs. ETFs
3.6.1 Tax Benefits
3.6.2 Simplicity
3.6.3 Cost-Effectiveness
3.6.4 Investing Flexibility
3.6.5 Low initial investment required
3.6.6 Trading Flexibility
3.6.7 ETFs usually have lower expense ratios
3.6.8 Transparency
3.6.9 ETFs offer options and short selling
3.6.10 Transferability
3.7 Index Funds vs. ETFs
3.7.1 Range of Indexes covered
3.7.2 Costs
3.7.3 Tax Efficiency
3.7.4 Dividends
3.7.5 Rebalancing
3.7.6 Dollar-Cost Averaging
3.7.7 Liquidity

4.1 Trading strategies for ETFs
4.1.1 Investing with ETFs
4.1.2 Gaining Industry Exposure with ETFs
4.1.3 Invest in Commodities through ETFs
4.1.4 Gain access to International Markets through ETFs
4.1.5 Bond ETFs
4.1.6 ETNs – a form of ETFs
4.1.7 ETFs and the Currency Market
4.1.8 Selling ETFs
4.1.9 ETFs to Hedge Risk
4.1.10 ETFs to Hedge Indexes
4.1.11 ETF options add to an investor’s options
4.1.12 ETFs role during Earnings Seasons
4.2 Market Index ETFs for Broad Market Exposure
4.2.1 Industry ETFs Sector Strategies
4.2.2 Country ETFs for Foreign Market Exposure
4.2.3 Foreign Currency ETFs for Interest Rate Exposure
4.3 Basic ETF Options for Playing the Earnings Season
4.3.1 Advanced ETF Options Strategies for Playing the Earnings Season
4.3.2 Commodity ETF Strategies when Commodities Impact Earnings
4.3.3 Inverse ETFs for Getting Short without Selling
4.3.4 Style ETFs
4.4 Investing Strategies with ETFs
4.4.1 Risk Management
4.4.2 International Exposure
4.4.3 Industry Exposure
4.4.4 Cash Flow Utilization
4.4.5 Price Discrepancy
4.4.6 Management Transitions
4.4.7 Market Analysis

5.1 Research Methodology
5.1.1 Return and risk
5.1.2 Regression analysis
5.1.3 Tracking Error
5.1.4 .Empirical Data
5.2 Selection and Justification of index funds

6.1 Return and risk
6.1.1 Regression analysis
6.1.2 Tracking error


II Bibliography

1 Abstract

As the ETF industry has grown by leaps and bounds in recent years, investors and advisors are finding themselves with more options than ever before. There's a vast universe of ETF investment options available, and once all opportunities are narrowed down and aligned with particular investment ideology, investors evaluate the ETF options on number of different criteria to identify and spot the most attractive one of all.

This paper examines the advantages and disadvantages of ETFs compared to index funds when investing in the German funds market. It examines total and average return, volatility and tracking error of ETFs versus index funds tracking the DAX. Also a regression analysis is done in order to draw conclusion on the funds’ alpha, beta and coefficient determinant.

It can be concluded that the hypothesis of whether ETFs are a cost-efficient way for institutional investors to invest in the DAX stands and evidence is provided. Results indicate that ETFs achieve higher average returns and less average volatility. In addition, ETFs pursue a better full replication strategy than index funds. As a result, the tracking error for ETFs is lower than the index funds’.

2 Introduction

Some studies have revealed that institutional investors put less emphasis on trading through stock exchange but prefer to directly create and redeem exchange traded funds. An exchange-traded fund is a type of investment product that represent basket of securities such as the DAX index and are made available only through brokers and advisors.

It was in 1993, that the American Stock Exchange launched the Spiders, SPDR to track the S&P 500. It was the first exchange traded product on markets with more coming later on. Diamonds was launched in 1998 which tracked the Dow Jones in industrial average and Cubes in 1999, which tracked the NASDAQ 100

But it was the mutual funds that were the most popular with institutional and private investors both for quite some time. This trend however is only now beginning to change as institutions find that ETFs can help attain a variety of goals that many other investment vehicles simply cannot provide. A recent survey from Greenwich Associates (carried out in 2010) that polled 70 investment firms revealed that ETF use is rising sharply. Among the highlights of the study: use of ETFs among pension funds, endowments and charitable foundations has grown to about 14%. Despite this relatively low number, institutional assets represent roughly half of the assets invested in ETFs suggesting that these funds play an increasingly important role in deciding which ETFs survive and which fall by the wayside. (

ETFs are popular among institutional investors to make rapid and large bets on oil, gold, waste-management and semiconductors sectors primarily. They also make use of ETFs to hedge their bets on stocks, bonds, commodities and other securities. In 2007, some ETFs were introduced for use in retirement accounts, as well as life-cycle ETFs, which invest more conservatively as investors approach retirement. All in all ETFs are known as index solution for investors looking to do the following:

- Diversify their investment
- Hedge against risk
- Gain exposure to a particular industry

DAX is the home country equity index for Germany. It also happens to be the biggest European ETF market by number of listings (on the Deutsche Börse’s XETRA platform) and reported trading volumes. The DAX ETFs benefit from a liquid futures market, which makes it very easy for market makers to hedge positions. Not much research has been made around ETFs in the German market. Hence, this paper will focus on the following:

2.1 Hypothesis

Exchange Traded Funds (ETF) can be a cost-efficient and profitable investment product for institutional investors compared to index funds (focusing on the German ETF market, specifically the DAX). This means in particular that ETFs tracking the DAX will outperform index funds tracking the same index.

2.2 Research Aim

To examine the hypothesis by considering the trend of ETFs and Index Funds with respect to the DAX in the past three years. The analysis of the trend will help determine whether ETFs are as cost-efficient as they are often proclaimed to be. The research aims to determine if ETFs are - compared to index funds- a profitable investment for institutional investors. It will also include a thorough examination of the features of ETFs and index funds.

2.3 Research Objectives

For in-depth examination of the hypothesis from all possible angles it is imperative that the following objectives will be kept so that the study is focused and directed towards drawing a reasonable conclusion:

1. Analyze deeply the characteristics of ETFs, exploring their advantages and disadvantages as compared to mutual funds and index funds.
2. Thoroughly analyze the German ETF and index funds market to better understand the underlying workings and patterns.
3. Compare the performance of the selected ETFs and index funds with the probable benchmark in the industry.
4. Summarize the results and arrive at a conclusion – state whether the hypothesis stands as it is or if negated. Summarize the reasons for arguments in favor or against the hypothesis.

2.4 Rationale behind this Dissertation

Exchange Traded Funds have been around for some time now but they are still the centre of attention for many institutional investors. They are often referred to as the “hottest investment product” of the new century. They possess the attributes of index funds along with being a low cost way to invest in shares. Basically, an investor may get significant advantage by combining index diversification with the flexibility of trading shares (Hehn 2005, p.1). This blend of index investing with its stock-like attributes is what makes Exchange Traded Derivatives an intriguing and appealing fund as an investment alternative to institutional investors.

According to experts, the market is growing continuously with annual growth of 30 to 40% likely over the next three to four years (Flood, Chris n.d.). In the United States private and institutional investors had access to Exchange traded Funds since 1993. On 11 April 2000, seven years later, Deutsche Börse AG launched the first European ETF segment XTF Exchange Traded Funds. It has emerged as the single most important trading platform for ETFs in Europe (Hehn 2005, p. 120). Since then, the volume invested in Europe and the number of existing funds has increased exponentially.

It is not surprising that during the last decade the number of passive investing instruments such as ETFs and open-end index funds has skyrocketed. The amount of capital invested in ETFs around the world was nearly $560 billion in January 2008, the number of ETFs creating in Europe since year 2000 hundred folded (ETFlab, p.8). The supply of ETFs and index funds has risen with demand and expanded outside the traditional benchmarks such as equity indices. There is not, however, a consensus on which of these two investment products ultimately outperform the other or if, in fact, they are equally well at matching the performance of the underlying benchmark. Some studies have found significant differences in performance between seemingly identical ETFs and index funds; but there is an abundance of results that conflict with each other. Even though ETFs are widely used in the German market, there exists hardly any academic research about ETFs and index funds tracking the DAX. But does it also apply for ETFs and index funds tracking the DAX?

2.5 Brief Background of Topic

2.5.1 What are Exchange Traded Funds?

Exchange Traded Funds can be an essential part of any investors’ portfolio. Some investors just base their portfolio on ETFs. They focus on ETFs in their portfolio which highlights the importance of the fund. To achieve diversity in their portfolio, such investors may just include a selection of a few ETFS while others may use ETFs to complement their existing portfolios. Whatever the scenario may be, it is evident that ETFs are fast gaining popularity among novice investors as well as sophisticated money managers and institutional investors (Hawkins, 2010). Therefore, it is vital to understand the concepts and structures of this rather attractive investment instrument so that as many benefits as possible may be achieved out of it astutely and intelligently.

Exchange Traded Funds (ETFs), in the simplest of terms are funds that track indexes. If you buy shares of an ETF, you are in essence buying shares of a portfolio that tracks the return and yield of its indigenous index. ETFs combine the array of a diversified portfolio with the simplicity of trading a single stock. Investors may purchase ETF shares on margin, short sell them, or hold them for the long term. (Nasdaq)

ETF holds assets such as stocks, bonds or commodities and trades close to its net-asset-value over the course of the trading day. An ETF combines the valuation feature of a mutual fund or unit investment trust with the tradable element of a closed end fund. Since 2008 ETFs can be not only passively managed but also actively managed because of the authorization by the U.S. Security Exchange Commissions (Claymore, 2009).

2.5.2 Passive Management

The fact that an ETF matches a particular market index with a computer model, without much human involvement in deciding which securities are to purchased and sold leads to a fund management style known as passive management (Rompotis, 2009). Passive management is the main distinctive feature of the ETFs, and it is rather advantageous to investors. Passive Management requires merely minor, periodic adjustments by the fund manager to keep the fund in line with its index. This is quite different from an actively managed fund, like most mutual funds, where the manager continually trades assets in an effort to outperform the market. For these reasons, the element of "managerial risk" is well mitigated by the ETFs. So when choosing the ETF, instead of hiring a fund manager, you are relying on the power of the market itself. (Nasdaq)

2.5.3 What are Index Funds?

According to the US Security and Exchange Commissions an "index fund" describes a type of mutual fund or unit investment trust (UIT) whose investment objective typically is to achieve approximately the same return as a particular market index (US Security and Exchange Commissions).

An index fund or index tracker attempts to mirror the movements of an index of a specific market irrespective of other market conditions. This is achieved by trying to hold all of the securities in the index, in the same proportions as the index or by statistically sampling the market and holding "representative" securities.

Many index funds are passively managed (no fund manger needed to periodically trade security and endeavor to beat the market, instead a computer model is used with the aim of ‘following’ the index instead trying to outperform it). This is advantageous in many respects. Firstly it results in lower fees (since no funds manager is hired) and it also results in lower taxes in taxable accounts. Also it must be noted that when said that index funds ‘attempts’ to mirror the movements of the index, it is vital to understand that they do not result in ‘exact’ values, due to the limitations of the computer models employed for the purpose. The difference between the index performance and the fund performance is known as the "tracking error" or informally the "jitter" (

2.5.4 What is the DAX?

DAX (pronounced as dax) is the German Share Index and the abbreviation for “Deutscher Aktienindex” (Bö The term DAX usually refers to the DAX 30, a blue-chip index that comprises the 30 major German companies trading on the Frankfurt Stock Exchange. It represents the total return which is about 80% of the stock market. Prices are taken from the electronic Xetra trading system. According to Deutsche Börse, the operator of Xetra, DAX measures the performance of the Prime Standard’s 30 largest German companies in terms of order book volume and market capitalization (

There is also the DAX 100 which is a German price-weighted index of that country's top 100 stocks. The DAX 100 includes names such as Bayer, Commerzbank, BMW, and Schering. The DAX 100 is part of the German Stock Exchange Index family. The German Stock Exchange publishes a DAX 100 price index (HKDX). The DAX 100 represents a broad, real-time market index that combines highly liquid, big-cap shares with wide diversification. The DAX 100 has a base date of December 30, 1987 and the base is 500. Together with the M-DAX of 70 midcap stocks, the DAX 100 is formed. (Investorglossary). There exists also the TecDAX which is a stock index tracks the performance of the 30 largest German companies from the technology sector.

This study will focus solely on the DAX 30 in order to limit the scope of this study.

2.5.5 What are Institutional Investors?

Institutional investors are organizations that make substantial investment by collecting sums of money of others and acting on their behalf i.e. investing those sums in securities, real assets and other investment assets. Types of typical investors include insurance companies, banks, retirement or pension funds, hedge funds, investment trust and mutual funds (Essential Finance 2003, p.172). So for example, an ordinary individual in today’s day and age hardly possesses huge amounts of money that he can invest properly to earn reasonable returns. So for such individual, institutional investors are a great help. Their tasks and responsibility is to collect little amounts of money from such individuals and when pooled, those little sums collected result in a large sum of money. That sum is then invested by the institutional investors in buying shares of a company or other investment assets. The return received from the investment is periodically distributed to the individuals from whom the money was collected in the first place. Thus, institutional investors can be useful because they will hold a broad portfolio of investments in many companies. This spreads risk, so if one company fails, it will be only a small part of the whole investment.

Institutional investors possess the ability to influence the management of corporations. Depending on their share holdings; they will be entitled to exercise the voting rights in a company. They can also actively engage in corporate governance. Also, because institutional investors have the freedom to buy and sell shares, they can play a large part in which companies stay solvent, and which go under. (Wikipedia)

2.5.6 What other alternatives are available for institutional investors for investment?

Institutional investors invest in a large variety of instruments in order to diversify risk. Other than ETFs, the main types of assets that they invest include real estate/property, securities and other types of assets such as stocks, bonds, commodities and derivatives.

2.5.7 Brief Background on the German ETF Market

The concept of ETF is fast gaining popularity in Germany amongst the institutional investors. Given that Germany is a high capital investment market, it can be well understood as to why ETFs would flourish in the region. The original German ETF was iShares MSCI Germany Index Fund (AMEX:EWG), which has had a rather intriguing price history for traders. It continuously exhibited good margins and volumes. It provides investment results that correspond with price and yield performance, before fees and expense, of the publically traded securities in the German market as measured by the MSCI German Index (ishares). Compared to the other countries in Europe, Germany tends to differ from them in several respects, especial in the area of private investment where it bears a strong resemblance to the US market as it is highly capitalized. EWG, is the longest running German ETF and trades particularly well, by global standards and could be a good indicator of the ETF market's potentials in Germany. (GermanyETFs)

Germany, as is common knowledge, is the birth place of some of the world’s largest corporations. It is often referred to as the driving force behind Europe’s economy. With the way Germany takes initiatives and courageously steps over boundaries to diligently pioneer in uncharted territories, it’s would not be irrational to expect this big capital market to develop its own versions of the ETF mixes that are likely to be common in the US and UK.

EWG has a portfolio of holdings which are relatively strongly weighted since the holdings relate to the big German corporations. This fact though apparently appealing can be occasionally disadvantageous as it results in the portfolio taking direct index moves. Since the individual higher weighted holdings tend to generate positive returns, it helps balancing out losses. Therefore there is great potential in the German market for overcoming its lows and follow and upside pattern. Lydon (2011) states that the German economy is the ‘bellwether’ for economic growth and health in Europe. He states that it is therefore essential to know, understand and monitor the signals exhibited by the German market from time to time. He also states that despite the adverse economic conditions as discussed in the New York Times reports and the Wall Street Journal Reports, Germany looks poised to continue growing and exhibiting positive market trends. Although Lydon points that economists and investors should keep a close watch on iShares MSCI Germany because if fear spreads about the eurozone debt crisis, Germany could get dragged down with it.

Tim du Toit (2011) writes about the aging German population with the majority of the people in the country between the ages of 60 to 80. This trend is predicted to continue such that the situation looks absolutely dire by 2060. But Germany's demographics are a potentially big asset for good movements in the investment market. The aging population is causing some rethinking of the funds markets generally which is resulting in the funds looking for better options for investment. This focus on better returns by the funds market will cause the funds markets in Germany to evolve for the better. It also means that there will be an increase in the number of institutional investors and this in turn will lead to a surge in the trading volume of investment assets such as ETFs and other securities etc.

Therefore it will be reasonable to expect the German market to be looking for more choices in the investment market. With respect to the ETF market in Germany, it can be expected to evolve so as to widen the scope and style of investments.

In the long term, it is very much likely that Germany's investment market will take up new options that the fund managers and the second tier investors develop overtime. In another few years, a range of possible financial investment products will incorporate a good mix of ETFs. The problem for the German market is where to put the cash. Therefore the ETF model, which is based on spreads and investment styles, is the best suited, most flexible approach to cover all the angles (Germany ETFs). Hence, there is quite a scope for ETFs in Germany in the near future (ETFlab, p.8).

Qualifiers to projections

Although the German market is strongly connected to the global market, investors should be conscious of the fact that it is indeed an immense and versatile economy in its own right, and that local issues do affect the market performance, thus affecting ETFs. The German market’s dynamic is moderately diverse and there is also the European element to consider whereby all European markets are essentially a part of the one bigger market, and are therefore influenced greatly by rising or declining situation of Europe as a whole.

Germany's demographic issues will definitely affect the local capital investment markets, both at institutional level and private investor level. Investors in German ETFs should be fully “au fait” with the situation, prior to investment (Germany ETFs). It is very much possible that the German government will itself participate and influence investment matters, with the aim of adding variety and volume as incentive and inducement to the prevalent range of investments. All foreign investors would be astutely recommended to make sure that they are fully aware of the trends and ramifications for their own interests, before they venture to make investment in the German market (DBresearch 2011).


3.1 Active vs. Passive Investment Strategies

A lot of research has been conducted in the field of active versus passive investments. Voicu (n.d.) states in his Journal of Financial planning that the two set of investors, namely passive investors and active investors, possess diverse mindsets. He states that passive investors are those that believe that one cannot consistently top markets to get better than average returns all the time therefore they cut down on costs and attempt to simply duplicate their respective investable universes. Active investors on the other hand are those that believe that they possess the astuteness and intelligence to effectively identify high performance investments to seek out better than average results. Therefore they seek out what they call, above average opportunities of investments. He further states that advocates of passive investment strategies believe that markets operate on the principle of ‘efficient market hypothesis’ – whereby all information is quickly reflected in the prices which therefore tend to be fair and accurate at any point in time. Therefore they believe that markets cannot be exploited to their benefits no matter how intelligent an investor maybe. On the other hand, advocates of active investing believe that there are mispricings in the market and that all information does not get immediately incorporated in the prices, therefore, an astute and perceptive investor can exploit the market situation to achieve better than average results.

Voicu (n.d) further elaborates in his journal article on the advantages and disadvantages of the two prominent investment strategies under discussion. He states that some of the advantages of passive investment strategy are low costs, reduced uncertainty of decision errors (trying to get returns above those of the market comes with the added risk of choosing the wrong investments in the case of active investment strategy), style consistency and tax efficiency. He further sheds some light on the ‘proper use of passive investment strategy’ and put forth the following key points:

- An index should accurately represent the universe of investment choices as well as the performance of the asset category it represents.
- An index should be investable.
- An index should be truly passive and objective.

Since ETFs have been in existence long enough to provide sufficient historical data for detailed analysis and are now a key focus when it comes to passive investment strategy.

3.2 Characteristics of Exchange Traded Funds (ETFs)

3.2.1 ETFs are easy to understand

The underlying workings and mechanism of ETFs are simple to understand. ETF simply reproduce an index. It offers the yields and return of the market. There is no managerial risk involved as no managers or third parties are involved in making ‘instinctive’ decisions, that may just go wrong when least expected to. The rules governing the ETFs have been laid out and are straightforward.

3.2.2 ETFs are transparent

Fraud can be eliminated by having more transparency. This fact is very crucial, especially after Bernie Madoff pulled off the largest Ponzi scheme ever revelead. Since then many investors lost faith in those investments. Mutual funds report their holdings quarterly, as do hedge funds, which mean that they are opaque most of the time. In fact, there is a lot of jostling prior to those public-reporting periods so it isn't completely certain what their holdings aremost of the time. ETFs on the other hand must report their holdings in order to be provided injunctive relief by the SEC. So investors can be certain that if they invest in an ETF they know what they are holding. They also do not have to depend on quarterly reports which show continued above market returns like Madoff issued (McMillan 2003, p. 48).

Investors can take a look everyday at the complete securities portfolio, key indicators and historical performance of an ETF (Fahrenbach, n.d.).

Not only do ETF investors get a head start on important information but because ETFs are exchange-traded, they can also react faster: ETFs are bought and sold like stocks, on an exchange. However unlike investing in stocks, with an ETF, it is as if you are investing in an entire market and diversifying your risk as though in a fund.

3.2.3 ETFs are cost-effective

There is a low fixed fee for management of an ETF. For ETFs based on standard indices, for example, this fee is in the neighborhood of 0.15 to 0.30 % per year (Fahrenbach, n.d.). There are no up-front sales charges and redemption fees at all for ETFs. Therefore it allows for saving money as well increasing opportunities for returns.

3.2.4 ETFs are secure

Exchange Traded Funds are investment funds, and thus benefit from the “legally enshrined” protection afforded by the Investment Act (Fahrenbach, n.d.). There is no ‘issuer risk’ involved and on and in fact, by purchasing an ETF, you acquire a widely diversified portfolio of securities that ultimately helps diversify the overall risk to a greater extent as compared to an investment in stocks of a few companies. This diversification is the central goal of modern portfolio management, since it lowers the risk of individual issues to that of the market (Fahrenbach, n.d.).

3.3 International Investment Market (esp. Us Markets and European Markets)

ETFs are a very popular investment instrument in the United States. Aggregated US ETF turnover exceeds turnover in stocks and is highly concentrated. The average daily dollar turnover of the largest five ETFs was $11 billion in 2008, three times as large as the average daily dollar turnover of the top stocks. Even more striking is the $34.9 billion average daily dollar turnover of the heaviest traded ETF (SPDR S&P 500) compared with that of the most active individual stock (Apple), which had an average daily turnover of $5.6 billion in 2008. In addition, the consolidated ETF dollar volume represents a growing percentage of all securities trades in the US. US equity focused ETFs dominate an increasingly wider variety of underlying indices. The centre of US ETF trading and listing is NYSE Arca. Of the 797 ETFs listed in the US market space, 706 are listed on NYSE Arca, representing $442 billion assets under management (AUM). This establishes an ETF platform with a high level of efficiency and market quality. Average daily matched volume in shares for ETF trading during December 2008 was 491 million, compared to 231 million during December 2007, representing a 112% increase (NYSE)

The popularity of ETFs has increased year after year in Europe. At the end of 2008, there were 698 ETFs in Europe. In 2008 the ETF assets under management in Europe rose 11.2% to surpass 102 billion. The number of ETFs increased by 49% with 219 new ETFs launched, and the daily average turnover of European ETFs increased by 22% to €1.45 billion. NYSE Euronext is the leading platform for listing and trading ETFs in Europe with approximately 400 listings of 350 ETFs from 15 different issuers. ETFs are available on a wide range of more than 260 indices that cover a variety of asset classes and market segments, including equities, fixed income, currencies, commodities, sectors and leveraged/inverse strategies. Leading international issuers continue to choose NYSE Euronext for their ETFs with a record 169 new listings introduced in 2008. Trading activity on NYSE Euronext has experienced strong growth as well. NYSE Euronext ETFs surpassed €363 million in average daily turnover in 2008, with daily average turnover rising 16.6% and the average number of trades per day increasing by more than 51% over the previous year. (NYSE)

3.4 Tracking Error

Tracking Error can be defined as the deviation between the return of the ETF or index fund and the index. This means literally that portfolio management was unable to replicate the return of their benchmark precisely enough (Spremann 2010, p.68). Technically, tracking error measures the amount by which an ETF’s return is likely to fluctuate above or below the performance of the index that it seeks to track. In essence this term is used more loosely to describe the actual gap between an ETF’s return and that of its index.

Basically there is a difference in the composition of the portfolio and the benchmark is kept to minimize the trading costs. The simplest way to construct a tracker would be to hold every security in the ETF with the same proportion as it composition in the index. The only hitch in this is that it increases trading costs as it involves holding a large number of securities. So in an effort to control the trading costs the tracker funds hold a selection of securities that are chosen so that they statistically replicate the performance of the index.

From February 1993 to December 1998, Elton et al. (2002) studied the most popular and longest running ETFs, the Standard & Poor’s Depositary Receipts (SPDRs). They concluded that cash dividend and management expenses are the two primary variables of tracking error. When tracking error includes the dividend reinvestment and deduction of management expenses, the net asset value return is lower than the S&P index return by 28 basis points. However, Blume and Edelen (2002), who studied S&P 500 index funds, concluded that there was almost no tracking error, thus the index fund tracked the benchmark quite closely. Harper et al. (2003) also found that iShares ETFs had no significant tracking error during their study period for the S&P 500 index. Gastineau (2004) concluded that transaction costs are the major variable of tracking error for index costs. He quantified these costs to be between 200 and 300 basis points annually in the Russell 2000 index. In addition, he concluded that the reason why S&P 500 ETFs underperformed their index fund competitors between the years 1994 and 2002 was partially due to the lack of proactiveness by the ETF managers during index changes.

3.5 ETFs tracking DAX

Majority of studies (just like those mentioned above) have been conducted for the US market, but only few academic researchers have been conducted for the German market. Röder (1997) analyzed the performance of an index fund and an index certificate tracking the DAX on the basis of quarterly annual returns between January 1992 and June 1996 without taking into account the tax structure. In addition, Röder set up a model which took into account the issue surcharges for funds and index certificates in Germany. In the next step, he expanded the model by taking into consideration the tax structure in Germany. However, the market situation and the tax structure have changed. Nowadays, index funds are traded at the stock exchange market so that for most of them there are no issue surcharges. In terms of taxes, the tax credit method was used for taxing dividends so that holders of index funds were able to achieve higher dividend yields than holders of certificates.

Reents (2006) analyzed the performances of index certificates and ETFs tracking the DAX between 2003 and 2006 for private investors who followed the buy-and-hold-strategy, taking into consideration transaction costs and taxes. He concluded that neither index certificates nor ETFs are outperforming one another. For different strategies, the one or the other is performing better for this period. At that time, there was a changeover in the dividend taxation system to the half-income system in Germany. The half income system achieved removal of the double taxation of distributed profits in a flat-rate form by providing relief both on the corporate level and the shareholder level. Since January 2010, dividends are not subjected to the half-income system but to the flat rate tax system. The flat rate tax is applied for all dividend products from which 25% flat rate tax + 5% solidarity tax are deducted from the distributed dividends.

3.6 Mutual Funds vs. ETFs

Kennedy (n.d.) states in his study that the following reason for any investor to prefer an exchange traded fund in lieu of a mutual fund.

3.6.1 Tax Benefits

One to the most prominent advantages that is often highlighted in the context of ETFs is that of ‘tax benefits’. Kennedy (n.d.) points out that due to the way the ETFs are constructed; ETFs only incur capital gains taxes when the fund is sold, however in contrast, in a mutual fund, capital gain taxes are incurred as the shares within the fund are traded during the life of the investment. ETFs are created through an “in kind” trade of ETF shares for an underlying basket of stocks/ETFs. So “baskets” are exchanged for shares of the ETFs as an in kind trade. A mutual fund however has to go out to the marketplace to buy or sell shares resulting into a taxable issue. Since the “in kind” trade is not a taxable event, investors only have to pay taxes when they sell the ETF (McMillan 2009, p.48 -49).

Haynes (2011) points out that with mutual funds, whenever their investments generate income or capital gains (profits from sales) the investor is liable to pay taxes. He goes on to explain that the shareholders who invest in mutual funds keep track on the taxes and closely watch on them continuously. This is the reason as to why the after tax return of an actively managed fund tends to be several percentage points less than its pretax return.

When it comes to taxes, ETFs have the following advantage, explained hereunder in detail:

Mutual fund investors need to be aware that before they sell the fund they must pay taxes on their funds’ income or gains periodically – either quarterly or annually. So for example, if a mutual fund is held for, say 20 years, the investor will need to pay taxes on the earnings from that fund each year (Haynes, 2011). In Germany, since 2010 effective with the flat rate tax system an investor has to pay 25% + 5% solidarity tax of the earnings for tax (, 2008).

With respect to ETFs, an investor can defer paying taxes entirely until he/she is willing to sell the funds. This allows the investor to keep more of their money invested elsewhere thereby earning relatively greater returns overtime (Haynes, 2011).

However, there could be also a disadvantage. Sauter (2003) points out that ETFs’ advantage of liquidity can reduce the effect of its tax benefit. Since investors can trade ETFs frequently and without restrictions, investors could diminish or even negate the tax advantages inherent in the indexing concept. If an investor trades frequently he/she realizes a high level of short-term capital gains, which are tax inefficient. I.e. effective 2010, he/she has to pay 25% of earnings for tax in Germany. In addition to that, he/she might have to pay hefty brokerage commissions and other costs as well.

3.6.2 Simplicity

Kennedy (n.d.) points out the simplicity of ETFs. ETFs are bought or sold at one price with one transaction. With mutual funds, shares in the asset are constantly being traded to hit a target price and seek a desired performance. Multiple trades, multiple prices, therefore they tend to slightly more complicated and intricate whereas ETFs are relatively simpler.

3.6.3 Cost-Effectiveness

Apart from being a simple form of investment, ETFs tend to be more cost-effective than mutual funds. Since shares in a mutual fund are actively traded and the fund itself is actively managed, unlike the ETFs which are passively traded and passively managed, they sometimes rack up large management fees. Fund managers have to charge for their time after all that they spend trading to achieve the target price. With an ETF, it’s one transaction. Just like purchasing a stock. This cuts down on fees and commissions. There will be multiple commissions associated with a mutual fund due to its activity and volume. (Kennedy, n.d.)

3.6.4 Investing Flexibility

With the passage of time, there are greater numbers of ETFs being released. This has given investors a great many number of options to be able to target a specific trading strategy. Commodity ETFs, Style ETFs, Country ETFs, even Inverse ETFs (Kennedy, n.d.). With so many ETFs available to investors, tracking the performance of a certain index or achieving a specific financial goal is likely to be more attainable with an ETF and with a mutual fund.

3.6.5 Low initial investment required

With almost all mutual funds there is a specific amount that the investors need to purchase so that they can buy the fund. That particular amount is referred to as the “minimum investment requirements” for mutual funds. This amount can usually range from $1,000–3,000, though some can exceed $25,000 (Kennedy, n.d.). In the case of ETFs, the investors are not bound by any such requirements. Investors are allowed to buy even a single share of an ETF without having to get a cash advance on a credit card (Kennedy, n.d.).

3.6.6 Trading Flexibility

Haynes (2011) highlights the trading flexibility of ETFs compared to the mutual funds. He points out that ETFs are traded constantly throughout the standard trading day (9:30 a.m. to 4:00 p.m., Monday through Friday) but with mutual funds, the buying and selling mechanism tends to differ. The investors interested in buying or selling the funds can place orders at any time throughout the trading day, but their orders will not get entertained until after the trading day ends at 4:00 p.m. each day. Now this delay that is imposed on trading by the mutual funds can be more than just an inconvenience — it can also be rather costly. So for example, any change in the market, any rise or fall, in response to an external circumstance (perhaps a news event), such as a decline in the interest rates or a rise in the price of oil, makes an investor want to buy or sell the investment immediately since there could be further changes in the price of that investment by the end of the day. So in the case of mutual fund, the investor has no other option but to sit and wait for the day to end and perhaps wish for the price of his/her investment to stabilize at some ideal point. However in with ETFs the investors can buy and sell the funds immediately, when they deem the price appropriate. However Haynes (2011) points out that just because ETFs can perform certain functions, it doesn’t mean that investors should rush to attempt those functions, merely for the sake of trying. Only those investors that have a considerable amount of experience and a great depth of knowledge and understanding of the options markets should ever attempt to use ETFs in this way.


Excerpt out of 64 pages


Exchange Traded Funds (ETF) - Are ETFs a cost-efficient way for institutional investors to invest in the DAX?
ETFs vs. INDEX FUNDS - Example DAX
Grenoble Ecole de Management
Catalog Number
ISBN (eBook)
ISBN (Book)
File size
770 KB
ETF, Index Funds, DAX, Finance, Finanzen, Funds, Mutual Funds, Exchange Traded Funds, Return, cost-efficient, profit
Quote paper
Minh Vu (Author), 2011, Exchange Traded Funds (ETF) - Are ETFs a cost-efficient way for institutional investors to invest in the DAX?, Munich, GRIN Verlag,


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