Leveling the Playing Field Between Mutual and ETF Index Funds

Gastineau in an early journal article argued that the returns for index exchange-traded funds ("ETFs") lagged the returns realized by large index mutual funds following the same indexes. The author believed a simple solution existed to ameliorate these return differences where both products track the same underlying index. 

Exchange-traded funds and mutual funds are subject to SEC Rule 22c-1 with respect to selling or redeeming their component shares. However, ETFs create and redeem their shares using a unique process that reduces tracking errors between the market prices of the funds and their affiliated net asset values. 

The author explained that tracking error normally followed the fund's expense ratio. In short, the managers of the exchange-traded index funds are striving to insure that their funds closely track the underlying, component securities. 

The author stated that creation and redemption of ETF shares amount to a structural weakness vis-à-vis conventional mutual funds. 

The author explained that the evidence showed that returns are better during normal trading times rather than at the times adjustments are made for the ETFs. For adjustment times he believed in the simple expediency of requiring the authorized participants which create and redeem shares to commit no later than 2:30 p.m. rather than waiting until right before the 4:00 p.m. deadline. This change would lessen the number of mistakes currently being made by authorized participants.

See DOI: 10.3905/etf.2004.664127