Examining the Relationship Between Liquidity and Tracking Error in Exchange-traded Funds

Open Access
Cannon, Jeffrey Daniel
Area of Honors:
Bachelor of Science
Document Type:
Thesis Supervisors:
  • Timothy T Simin, Thesis Supervisor
  • James Alan Miles, Honors Advisor
  • Finance
  • Exchange-Traded Funds
  • Tracking Error
  • Liquidity
Recent financial studies proved that domestic exchange-traded funds control their tracking error efficiently because of constant arbitrage. The arbitrage methodology then suggests that all domestic exchange-traded funds’ tracking errors should statistically be affected by liquidity unless the fund is extremely liquid or illiquid. The methodology further suggests, and recited in financial literature, that the least liquid funds have the largest tracking errors. This study provides regression results suggesting that the relationship between liquidity and tracking error is not statistically significant for all domestic exchange-traded funds. The inconsistency of the least liquid funds having the largest tracking errors further suggests a weaker than proposed relationship between liquidity and tracking error.