European Bond ETFs: Tracking Errors and the Sovereign Debt Crisis

Date01 November 2014
Published date01 November 2014
European Financial Management, Vol. 20, No. 5, 2014, 958–944
doi: 10.1111/j.1468-036X.2012.00649.x
European Bond ETFs: Tracking Errors
and the Sovereign Debt Crisis
Mikica Drenovak
Faculty of Economics, University of Kragujevac, Serbia
Branko Uroˇ
Faculty of Economics, University of Belgrade, Serbia and National Bank of Serbia
Ranko Jelic
University of Birmingham, Business School, Birmingham, B15 2TT,UK
This study examines the tracking performance of 31 eurozone sovereign debt
exchange traded index funds (ETFs) during 2007–2010. The tracking performance
is assessed by four different tracking error models. Overall, funds underperform
their respective benchmarks. Active returns (net of fees) vary substantially (from
+46.74 to 30.36 basis points) and are of considerable economic interest.
The significant differences in the performance of swap-based and in-kind funds
highlight the importance of appropriate (e.g. correlation vs. cointegration based)
metrics requiredfor the assessment of funds adopting different replication methods.
We also document important changes in the tracking performance due to the
changing characteristics of EU sovereign bonds since the start of the sovereign
debt crisis.
Keywords: exchange-traded funds,tracking errors,fixed-income,sovereign debt
JEL classification codes: D81, E43, G15, G24
The authors are grateful to three anonymous referees and John Doukas (the editor) for
valuable comments. We thank Sergey Gelman, Drago Indjic, Miles Kumaresan, Carsten
Sprenger, FelixGoltz, Chien-Hui Liao, Jose Garcia-Zarate, and Florian Bitsch, participants at
the European Financial Management Symposium on Alternative Investments,Toronto (April,
2011), and seminars at the ICEF- Moscow (May, 2011) and National Bank of Serbia (June,
2011) for their valued input. Mikica Drenovak and Branko Uroˇ
c gratefully acknowledge
the support of the Serbian Ministry of Science and Technology, Grant OH 179005. The views
presented in this paper are those of the authors and do not necessarily represent the views of
our respective institutions.
2012 Blackwell Publishing Ltd
© 2012 John Wiley & Sons Ltd
European Bond ETFs 959
© 2012 John Wiley & Sons Ltd
1. Introduction
In times of market distress and high uncertainty, investors typically rebalance their
portfolios towards less risky and more liquid assets (Longstaff, 2004). The ‘flight
to quality’ associated with the recent financial crisis spurred the development of the
eurozone sovereign debt exchange traded funds (ETFs), which today represent one of
the fastest growing segments of the overall European ETF market. For example, in 2009
these products gathered $6.2bn in new cash, which represented 7.5% of total inflows in
all European ETFs.1The sheer number of such funds, their liquidity, and the significant
total assets under management make them one of the most important new investment
Despite their increasing importance, there is a paucity of research on the European
EFTs and the analysis of ETF tracking errors remains a widely misunderstood and
frustrating process for investors (Flood, 2010a).2Drenovak and Uroˇ
c (2010) is the
only previous study on the performance of EU sovereign ETFs. The authors discuss
institutional issues related to the eurozone sovereign debt ETF market and perform a
preliminary ranking of funds based on the standard correlation-based tracking error
method. In this paper, we examine the tracking performance of 31 eurozone sovereign
debt exchange traded index funds between January 2007 and December 2010. We
contribute to the existing literature by examining the tracking performance using four
different models, including cointegration analysis. We further present novel evidence on
the determinants of tracking errors using panel data analysis and consider the impact
of the tracking method (i.e. in-kind vs. synthetic replication) and the financial crisis on
tracking errors.
The new evidence on the tracking performance is particularly important in the
European context for the following reasons. First,since the collapse of Lehman Brothers,
several EU governments have implemented various measures aiming to stabilise their
troubled financial systems, which were further followed by the divergence in credit
spreads of EU countries.3Before the crisis, the risk associated with euro sovereign bond
indexes was lowand almost entirely attributable to the yield curve risk. During the crisis,
the risk of euro sovereign indexes rose sharply. Notably, sovereign bonds from so-called
peripheral EU countries such as Belgium, Greece, Italy,Ireland, Portugal and Spain have
become more akin to corporate bonds.4The above changes in the European bond market
are expected to have an important impact on the tracking performance of the sovereign
1By mid 2009, there were 753 registered European exchange traded funds (ETFs) with assets
under management (AUM) of overUS$ 183 bn. The propor tion of fixed income ETFs in the
total ETF assets grew from 5% in 2003 to more than 25% in 2009 (calculations made by the
authors, based on data from Barclays Global Investors (2009), Flood (2010b) and iShares
2Edhec (2009) reports that only 50% of European investors see ETFs’ tracking quality as
fairly good.
3We take the end of August 2008 (i.e. the collapse of Lehman Brothers) as the beginning of
the sovereign debt crisis.
4The changes are sometimes described as the new risk and return paradigm in the bond
market (see Nomura, 2011; p.80).
Mikica Drenovak, Branko Uroševic´ and Ranko Jelic
© 2012 John Wiley & Sons Ltd
Second, a new debate has recently emerged on the merits of synthetically structured
(i.e. swap-based) ETFs compared to those that use the underlying assets to track the
benchmarks (i.e. physically-based or in-kind funds). The proponents of physically-
based funds highlight the counterparty risk that exists with synthetically structured
funds, while the proponents of synthetically structured funds would argue that swap-
based funds deliver the lowest tracking errors.5Importantly, the largest European ETF
providersf avourdifferent structures. For example, the UK market predominantly consists
of physically-based while German and French markets are dominated by swap-based
ETFs. Given this segmentation of the European market and substantial differences
within the individual product structures, it is important to examine the various types of
ETFs and to compare their tracking performance.
Bond indices are expected to be less volatile than major equity indices. They also tend
to have far fewer constituents than leading equity indices (e.g. S&P). It is, therefore,
expected that passively managed ETFs tracking sovereign bond indices should exhibit
consistently low tracking errors similar to their total expense ratio (TER). Our results,
however, show substantial levels and variations in tracking errors for passively managed
European sovereign bond ETFs. The tracking errors are higher than those reported for
US Treasury bond ETFs (Houweling, 2011) and US passive equity ETFs (Blume and
Edelen, 2004). In some cases tracking errors are more than three times higher than their
TERs and are, therefore, more in line with results for corporate bond ETFs reported in
the previous literature. Importantly, some funds (e.g. Lyxor) consistently outperformed
benchmarks. Both univariateand our panel data analysis reveal a significant deterioration
of the sample ETFs’ tracking performance during the crisis period.
We further document that, as a result of the sovereign debt crisis, credit risk
considerations (i.e. credit default swaps (CDS) of index constituents) are increasingly
important for the tracking performance of sovereign bond ETFs. We also find strong
evidence for the importance of volatility of underlying indexes, duration, the replication
method, bid-ask spreads, TER, and ETFs’ size for the tracking performance.6Overall,
our results suggest that producing ETFs which genuinely match performance of
European sovereign bond indexes has become more complex in recent years. Each
ETF should, therefore, be assessed on its own merits based on error metrics suited to
fund characteristics and target indexes.
The remainder of the paper is organised as follows. In Section 2 we present important
characteristics of euro sovereign debt ETFs and their underlying indexes. Section 3
discusses relevant literature and motivates the hypotheses. Section 4 describes the
data and provides sample descriptive statistics. Section 5 presents the methodology
for assessment of tracking performance. The results of our sample ETFs’ performance
analysis are discussed in section 6. Section 7 presents the results of our panel data model
for determinants of the tracking performance. In Section 8, we test for robustness of our
results. Section 9 concludes.
5Controversially, the synthetically structured ETFs have been mentioned as a possible new
source of systematic risk by the Financial Stability Board, the International Monetary Fund,
the Bank for International Settlement and the Securities and Exchange Commission (SEC).
See Ramaswamy (2011), International Monetary Fund (2011), Financial Stability Board
(2011), Aboulian (2011) and The Wall Street Journal (2011).
6Our results are robust to use of data from different providers, alternative proxies, and
alternative panel models specifications.

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