Advanced Science and Technology Letters
Vol.57 (Business 2014), pp.46-49
http://dx.doi.org/10.14257/astl.2014.57.11
Comparison Analysis of Conventional Index Funds and
Exchange-Traded Funds
Young Kyu Park1, Hyun Ju Jung, Hae Song Choi
School of Business, Sungkyunkwan University
Abstract. This research investigates why seemingly indifferent financial
products, ETFs and conventional index funds, coexist in the Korean financial
market. Our findings are as follows. First, both ETFs and index funds track
their underlying indexes closely and their tracking errors are not different.
Second, cash flows to one type of product do not affect the cash flows of the
other product. Third, tax clientele effect does not shift the cash flow between
ETFs and index funds. Fourth, we can explain the coexistence of ETFs and
index funds with the behavior of fund investors who prefer different
characteristics of these funds. We conclude that ETFs and index funds are not
substitute and investor choose one type over the other depending on their
specific investment characteristics.
Keywords: Index Funds, ETFs, Tracking Error, Substitution Effect,
Clientele Effect, Fund Cash Flow, Investor Behavior
1
Introduction
Passive fund such as index fund and ETFs(Exchange-traded funds) have attracted
many investors and have become the fastest-growing segment of the Korean capital
market. It is an efficient way to minimize risk of stock portfolio with relatively low
cost. As of June 2012, there are 121 ETFs and 238 index funds available in the Korea
market with their assets totaling approximately KRW 2.15 billion. 2 These passive
investment vehicles have increased their size about 8.05 folds from 2004 to June
2012. This is a remarkable growth considering that the total fund market size has
increased only 1.63 folds during this period (from 19.01 billion won to 30.99 billion
won). ETFs have become the fastest-growing segment of fund market recording an
increase of 40.89% per year during this period. The growth of the index funds is
relatively slow when it is compared to ETFs, but their size are currently similar, KRW
1.16billion won for ETF and KRW 0.99 billion won for index funds.
Thus the research question for this study is raised. Why do ETFs and index funds
co-exist in the market at similar size in spite of their almost same service feature? In
economic theory, if two products are substitutes, an increase in demand for one
product should results in a decrease in similar product. Intuitively, ETFs looks like
1 Young Kyu Park, School of Business, Sungkyunkwan University, 3-53 Myungryun-dong, Jongno-gu,
Seoul 110-745, Korea. Tel: +82-2-760-0418, Fax: +82-2-760-0145, email: [email protected].
2 Korea Financial Investment Association , http://freesis.kofia.or.kr/
ISSN: 2287-1233 ASTL
Copyright © 2014 SERSC
Advanced Science and Technology Letters
Vol.57 (Business 2014)
more efficient vehicle than index funds since ETFs has higher liquidity and lower fees
than index funds. Therefore, ETFs should dominate the passive fund investment and
conventional index funds should gradually disappear or lose significant market share
to ETFs. However, these two vehicles have been coexisted and both products are
exponentially growing up together in the Korean fund market. Therefore it is our
interest to find out the reasons why the seemingly same two investment vehicles
coexist.
While a great deal of studies examine performance, investment style, and structure
of mutual funds, limited number of literatures are available on the subject of ETFs
and index funds due to the limited data given their short history. (Elton et al. (2002),
Gastineau (2004), Guedj and Huang (2003), Shoven (2002), and Agapova (2011))
Therefore this study can be a meaningful addition to this passive investment research.
2
Methodology
In this study, Substitution effect is examined by comparing fund cash flow effect of
index funds and ETFs (Agapova, 2011) toward each other. We run a regression where
the cash flow of index fund i (or ETF i ) at time is the dependent variable and the
cash flows of ETF i (or index fund i ) at time t is the independent variable as shown
in equation (1):
FlowIF(ETF)i,t  αi,t  β1 FlowETF(IF)i,t  β2 FlowIFi,t 1  β3 FlowETFi,t 1
 β4 FlowIndustryi,t  β5TargetRet i,t 1  β6 IF(ETF)Ret i,t  β7 IF(ETF)Ret i,t 1
(1)
 β8 Expenses i,t  β9 LogNAVi,t  β10 IRi,t  εi,t .
We calculate cash flows using the conventional methodology in Sirri and Tufano
(1998). In equation (1), the cash flow of ETF(or IF) i at time t , FlowETF ( IF ) i ,t ,
is main explanatory variable and FlowIFi,t 1 and FlowETFi,t 1 are control variables
because of the persistency of cash flows(Cashman et al., 2007). FlowIndustryi ,t is the
cash flows of the fund market as a whole, which can represent the level of fund
investments and investor’ confidence about the fund investment at time t. Since cash
flows to individual fund increase when cash flows to fund industry increase, we use
this variable to control the fund market sentiments. TargetReti,t 1 is the return of
benchmark in the previous period which shows the recent performance of benchmark
index. IF ( ETF ) Ret i,t and IF ( ETF ) Ret i,t 1 indicate the rate of return (=performance) of
index fund(ETF) i at time t and t  1 , which shall directly influence the dependent
variable. Expenses i,t is the total expenses of fund i and LogNAVi,t is the logarithm
of the total net asset value, which is used to control fund’ size effect. Lastly, we add
Information ratio ( IRi , t ) as an additional control variable for the risk adjusted fund
performance.
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Advanced Science and Technology Letters
Vol.57 (Business 2014)
We also examine whether the increase in the tax expense of index funds affect the
flow between ETFs and index funds. Since 2010, securities transaction tax exemption
of mutual fund is finished and 0.3% of stock sales tax is implemented for the fund.
Therefore, the end of securities transaction tax exemption for mutual fund is expected
to reduce the return of index fund significantly because index fund incur more
frequent transactions compared to ETFs. We add a dummy variable, which is 1 if it is
the cash flows of index funds after January 1st, 2010 for this test.
We also check tax clientele effect of index fund with Individual Retirement
Pension (IRP) and Long-term Housing or Long-term Equity Fund (LTHF/LTEF).
These instruments provide a deferred tax benefits to index funds. We hypothesize that
cash flow to IRP index fund or LTHF/LTEF negatively influences the cash flow to
ETFs if there exist tax clientele effect and substitutability between two investment
products.
We also try to explain the coexistence of ETFs and index funds by observing the
behavior of fund investors. We expect that there may be different determinants for
ETFs and index funds from the investor’s perspective. First, we run the regression (2)
3 to examine the relation between the cash flow of ETF and fund characteristics which
can influence ETF investment decisions:
FlowETFi,t =αi , t  1 flowi,t-1+ 2 fundPerfi,t-1+ 3 fundTNAi,t-1
+ 4 FamTNAi,t-1+ 5 fundage+6 expensei,t-1
(2)
 7 First+ i , t .
The cash flow of ETF i at time t  1 ( Flowi ,t 1 ) is used as a control variable
because of the persistency of cash flows. (Cashman et al, 2007) We use the riskadjusted return calculated from the three-factor model (Fama and French, 1993) as a
measure of fund performance. fundTNAi,t-1 and FamTNAi,t-1 are the logarithm of the
lagged total net asset value of the fund and the fund family which manage the fund i.
fundage is the number of years since the fund launch date. expense i , t  1 is the
lagged total expenses. First is dummy variable which is 1 if ETF is the first launched
product among the ETFs that track the same benchmark. The first launched ETF
usually take advantage because of the first occupation effect.
In regard to the cash flow of index funds, we use bigvendor as a new independent
variable instead of First variable in equation (2). bigvendor represents the dummy
variable which is 1 if the fund is sold by the financial institution whose TNA is over
0.8 billion. We expect that channel of distribution is important determinant since the
cash flow of index funds may depends on the distribution power of vendor.
3 Since the residuals may be correlated across firms or across time, and OLS standard errors can be
biased, we run regressions with clustered standard errors throughout this study.
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Copyright © 2014 SERSC
Advanced Science and Technology Letters
Vol.57 (Business 2014)
3
Test Results and Conclusion
Although previous studies have examined conventional index funds and exchangetraded funds (ETFs), they have focused on tracking errors and price efficiency of
ETFs, or the effect of ETF introduction on the index funds in Korean market. This
study tries to find empirical explanations of the substitutability and coexistence of two
investment vehicles. 399 index funds and 16 ETFs following 6 benchmark indexes
have been used for the period from January, 2006 to December, 2011. Our test results
are as follows.
First, the mean tracking error is 0.007786 on average that indicates ETFs and
conventional index funds generally track their underlying indexes closely. Mean of
tracking errors are not statistically different between the fund types, but ETFs have
smaller tracking errors on average. Second, we find that conventional index funds and
ETFs are not substitutes, and flows to one fund type do not affect the flow to the
other. Third, tax related clientele effects do not seems to influence the cash flow
between ETFs and index funds as investors do not consider them as substitutes.
Fourth, the coexistence can be explained by the behavior of fund investors who prefer
different characteristics of these funds - we found that while the cash flow of ETFs is
influenced by fund performance, fund family performance, and fund expense, the
cash flow of index funds is influenced by fund size, fund age, and the existence of big
vendors.
This paper contributes to the literature by empirically investigating the
substitutability between ETFs and index fund and provided plausible explanation of
the coexistence of seeming indifferent investment vehicles.
References
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Financial Markets. 14, 323--343 (2011)
2. Cashman, G. D., Deli D. N., Nardari, F., Villupuram, S. V.: Investor Behavior in the Mutual
Fund Industry: Evidence from Gross Flows. Working paper. (2007)
3. Elton, E. J., Gruber, M. J., George, C., Li, K.: Spiders: Where are the Bugs?. Journal of
Business. 75, 453--472 (2002)
4. Fama, E.F., French, K. R.: Common Risk Factors in the Returns on Stocks and Bonds.
Journal of Financial Economics 33, 3--56(1993)
5. Gastineau, G. L.: The Benchmark Index ETF Performance Problem. Journal of Portfolio
Management 30, 96--103 (2004)
6. Guedj, I., Huang J. C.: Are ETFs Replacing Index Mutual Funds? Working Paper(2009)
7. Poterba, J. M., Shoven, J. B.: Exchange Traded Funds: A New Investment Option for
Taxable Investors. American Economic Review. 92, 422--427 (2002)
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