Active vs.

Passive Management: New Evidence from Exchange Traded Funds

by

Gerasimos G. Rompotis
Senior Auditor- KPMG Greece
Researcher- National and Kapodistrian University of Athens, Greece
25 Ypsilantou Street
Peristeri, Athens, Greece
GR 121 31
+0030 210 5776510
grompotis@kpmg.gr

Abstract
This paper expands the debate about active vs. passive management using data from
active and passive ETFs listed in the U.S. market. The results reveal that the active
ETFs underperform both the corresponding passive ETFs and the market indexes. With
respect to risk-adjusted returns, both active and passive ETFs provide investors with no
positive excess returns, an expectable finding for the passive ETFs but not for the active
ETFs which are aimed at beating the market. Going further, the underperformance of
active ETFs is depicted to the low performance rates such as the Sharpe or the Treynor
ratios they receive relative to the passive ETFs and the indexes. Furthermore, regression
analysis on the selectivity and market timing skills of ETF managers indicate that the
managers of both the active and passive ETFs are lacking in such skills. However, the
passive managers are not expected to have such skills. Finally, tracking error estimates
indicate that the discrepancy between ETF and index returns is greater for active ETFs.
However, this result is to be expected as the active ETFs do not target to replicate the
performance of the indexes.

February 2009

JEL CLASSIFICATION: G12, G15

Keywords: Active ETFs, Performance, Managers, Selection Skills, Market Timing

Electronic copy available at: http://ssrn.com/abstract=1337708

1. Introduction
The performance of actively managed mutual funds and the ability of managers to
produce above-normal returns have been thoroughly examined by the literature. Blake
et al. (1993), Malkiel (1995), Gruber (1996) find that the actively managed portfolios,
on average, do not produce better returns than the market indexes or the passively
managed index funds. The authors connect the inability of managers to beat the
market with the increased expenses incurred by the active management. In contrast,
Ippolito (1989) alleges that the fee- and expense-free risk-adjusted returns of mutual
funds are comparable to returns delivered by index funds while the portfolio
management fees do not affect funds performance. However, the findings of Ippolito
are subject to the benchmark employed and experienced extended critique by the
literature. In general, the inability of active mutual funds to generate persistent superior
returns along with the low expenses of indexing contributed to the massive growth of
indexing and to the boosting of the passively managed investing products, like index
funds or ETFs.
Two significant elements that affect the performance of active mutual funds are
the security selection and the market timing ability of managers. The selection ability
implies that the manager can predict the future return of individual securities and picks
these that could perform better. The timing ability indicates that the manager increases
successfully the portfolios exposure to the market index prior to market accessions and
decreases exposure before the market recessions. On the other hand, passive managers
are not supposed to possess any selectivity and timing skills since their core investing
strategy is to invest to the holdings of a benchmark portfolio trying to replicate its
performance.
The findings of the literature on the selectivity skills of fund managers are
ambiguous. Carhart (1997) finds no evidence on skilled or informed portfolio managers.
However, Jensen (1969) and Elton et al. (1992) find limited evidence that managers
who apply stock selection strategies can produce positive superior returns over long-run
periods. Also, the literature accentuates the existence of selection ability over short-run
periods, whose length does not usually exceed the one year. Goetzmann and Ibbotson
(1994), Grinblatt et al. (1995), Wermers (1999) reveal some evidence on successful
security selection, which partially explains the short-run persistence in mutual funds
performance.
Considering the ability of managers to time the market, the records of the
literature are as mixed as the findings about the stock selection ability. Treynor and
Mazuy (1966), Henriksson and Merton (1981), Chang and Lewellen (1984), Henriksson
(1984), Graham and Harvey (1996) report limited or non-existent market timing ability.
The main characteristic of these studies is that returns are considered monthly or
annually. The usage of more frequent return data could lead in different inferences
about the managers market timing ability according to Bollen and Busse (2001) and
Chance and Hemler (2001). Indeed, these authors adopt daily return data and
demonstrate that the mutual fund managers exhibit significant timing abilities.
This paper expands the research on active vs. passive management and fund
managers selection and timing skills using data of three active ETFs recently launched
in the U.S. market and comparing them to the corresponding passively managed ETFs.
These active ETFs were created by PowerShares. The study covers the period from the
inception of active ETFs on April 30, 2008 up to the end of November, 2008.
Active and passive ETFs have significant structural differences. The very basic
difference between them is that the passive ETFs are structured to track a specific
public market index while the active ETFs aim at beating the market. Active ETFs are
1
Electronic copy available at: http://ssrn.com/abstract=1337708

assigned a benchmark index while they are usually designed to track a popular
investment managers top picks, mirror any existing mutual fund or pursue a particular
investment objective and target to offer investors above-average returns. Other
differences between the passive and active ETFs concern the number of market makers
required by each type of ETFs (at least two and one market maker for passive and
active ETFs respectively), the minimum size of investment (not required by passive
ETFs but required by active ETFs) and the relationship between the market maker and
the ETF manager. More specifically, these investing participants are not related to each
other for passive ETFs while the market maker and the manager of an active ETF
belong to the same company.
To the best of our knowledge, XTRA was the first exchange where actively
managed ETFs were traded while the U.S. market launched active ETFs for the first
time during 2008. The reason that active ETFs are not yet widely available relates to the
arbitrage opportunities offered by passive ETFs but not offered by active ETFs.
Arbitrage opportunities arise when a declination between the trading prices of ETFs and
the value of underlying securities exists. The efficient arbitrage execution contributes to
the narrowness of these divergences. Arbitrage bases on the in kind creation/redemption
process of passive ETFs and it is attainable because the holdings of the tracking market
indexes are publicly known throughout the trading day. In contrast, the stocks held by
the actively managed ETFs are not publishable information until the end of the trading
day because these stocks are picked by active ETFs so that they can beat the benchmark
index. Therefore, if the holdings of active ETFs are disclosed frequently enough so that
arbitrage could take place, their ability of beating the market weakens. In such a case,
investors would simply let the fund managers do all of the research waiting for the
disclosure of their choices and they would then buy the selected securities avoiding to
pay the management fees. Thus, the arbitrage and the in kind creation/redemption are
non-events for active ETFs.
Our results show that the active ETFs fail to beat the market. We assess market
returns by alternatively use the benchmark assigned to each ETF and the Standard and
Poors 500 Index. We use the two alternative benchmarks because PowerShares report
the returns of their ETFs in reference both to the single benchmarks and to the S&P
index. Moreover, the active ETFs (in two out of the three cases) underperform their
passive ETF counterparts. Considering risk-adjusted returns, both active and passive
ETFs do not provide investors with any positive excess return. While this finding is
natural for passive ETFs, it is not for active ETFs which are aimed at beating the market
and delivering above normal market returns. Going further, we rate the performance of
active ETFs, passive ETFs and market indexes and find that the active ETFs basically
receives lower ratings than the passive ETFs and market indexes. Considering the
security picking and market timing skills of ETF managers, the results indicate lack of
such skills for active ETFs. The same pattern applies to passive managers, who are not
expected to have such skills anyway. In the last step, we compare the active and passive
ETFs using the tracking error, which estimates the return difference between ETFs and
indexes. Results indicate that in any case the active ETFs have greater tracking error
than passive ETFs; a result that was to be expected since active ETFs do not target to
replicate the performance of the indexes.
The remainder of this paper is organized as follows. In Section 2 we develop the
methodology used in explaining and rating the various types of risk-adjusted return, in
evaluating the selection and timing skills of ETF managers and measuring the tracking
error of ETFs. Section 3 describes the data used in this study and provides the
descriptive statistics of the sample. The empirical findings are presented in Section 4
and the summary and conclusions are discussed in Section 5.
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Electronic copy available at: http://ssrn.com/abstract=1337708

2. Methodology
2.1 Risk-Adjusted Performance
To analyze the managerial skill to achieve superior returns by picking stocks that could
outperform the index we use the risk-adjusted return in Jensens model:
Rp,i-Rf = p,i + p,i(Rm-Rf) + p,i

(1)

where, Rp,i denotes the daily portfolios return for the samples ETF i. Rm represents the
return of the market portfolio and Rf is the risk-free rate, expressed by the daily risk-free
return provided by Frenchs website. The coefficient p,i (Jensens alpha) is used to
determine the excess return of the ETF i and measures the stock selection ability of the
managers. If the market is efficient and the portfolio of ETF i is properly priced, the
expected alpha should not be different to zero. Positive and significant alphas indicate
that the manager adds value while negative and significant alphas indicate that the
manager fails to well diversify the portfolio he manages or that he picks stocks that are
overpriced. However, we should note that this analysis basically applies to the active
ETFs because the flexibility for passive ETF managers to choose stocks or other
securities that are different to these that compose the tracking index is limited or nonexistent.
The coefficient i measures the part of the ETFs i statistical variance that
cannot be mitigated by the diversification provided by the ETF portfolio, because it is
correlated with the return of the other stocks that are included in portfolio. Beta stands
for the systematic risk of ETF i and evaluates the degree of its sensitivity to the
movements of the benchmark. i represents the residuals of regression equation (1).
2.2 Rating Performance
In this section, we rate the performance of ETFs. The first rate we use concerns the total
percentage returns achieved by ETFs during the studying period. We calculate total
return by subtracting the return on the first day of the studying period from the return on
the last day of the period and dividing to the return on the first trading day. The total
return of indexes is also calculated.
The second rating method we use is the Sharpe ratio, which is estimated via the
following equation (2):

S p ,i =

R p ,i R f

(2)

p ,i

where, R p ,i denotes the average daily portfolios return for the ETF i and R f is the
average daily risk-free rate. p.i is the standard deviation of ETFs i return used as a
proxy for the ETFs risk. The Sharpe ratio is estimated by the division of ETFs i excess
return to its risk and is used to determine how well the return of the ETF i compensates
the investor for the per unit risk they take. The higher the Sharpe ratio is, the better is
the performance of ETF.
Additionally to Sharpe ratio, we estimate the Treynor ratio which is expressed
by the next formula (3):

T p ,i =

R p ,i R f

(3)

p ,i

where, R p ,i and R f are defined as above and p,i is the systematic risk of ETF i.
Again, the higher the Treynor ratio is, the better is the performance of ETF.
The last criterion used to rate the performance of ETFs is the Jensens alpha
derived from the regression equation (1). Positive (negative) and significant values of
alpha are connected with value-adding (non value-adding) portfolio management and
therefore ETFs with such alphas should be placed at the top (bottom) of the ranking.

2.3 Testing Market Timing Ability

In general, the market timing ability of fund managers implies the efficient increase or
decrease in the portfolios exposure on equities prior to market accessions or decreases,
respectively. However, the managers market timing ability is affected by the investing
objective of the fund, which probably obliges the manager to keep the same maximum
or minimum portion of equities in his portfolio. In this case, the manager tries to time
the market just by adjusting the equity synthesis of the portfolio, substituting the
overpriced stocks by undervalued stocks. The successful market timing is also affected
by the restricted or unrestricted usage of leverage and derivative products.
To test the market timing ability of ETF managers we use the model developed
by Treynor and Mazuy (1966) and described in Bollen and Busse (2001) and (2004).
The model is expressed by the following equation (4):
Rp,i-Rf = p,i + p,i(Rm-Rf) + p,i(Rm-Rf)2 + p,i

(4)

where, Rp,i, Rm and Rf are defined as above and p,i measures timing ability. If the
manager increases (decreases) efficiently the portfolios exposure to market index prior
to market accessions (recessions), p,i will be positive resulted from a convex function
of portfolios return with respect to market return. We note that we apply model (4) to
passive ETFs too but we do not expect the passive ETF managers to present any
meaningful timing skills as they are not required to. They just need to follow the
tracking index and to timely adjust their portfolios whenever the synthesis of the
benchmark changes.
Bollen and Busse (2001) suggest that the daily tests on market timing are more
powerful than monthly tests and that mutual funds exhibit more significant timing
efficiency in daily tests than in monthly tests. In our paper, we evaluate the market
timing skills of ETF managers using daily data and expecting statistically significant
estimations for coefficients of models (4) for active ETFs and insignificant estimates
for passive ETFs.

2.4 Estimating Tracking Error

The deviation between the performance of index funds and the performance of the
corresponding indexes is defined as tracking error and this issue has attracted great
interest in the literature. The most common issue in passive portfolio management is
that fund managers usually fail to replicate accurately the return of their corresponding
indexes. In our study, we choose the three most commonly used methods of tracking

error measurement described in Frino and Gallagher (2001). The first one, 1,, is
straightforward and defined as the standard error of performance regression (1).
The second one, 2,, computes the tracking error by calculating the average of
absolute differences between the returns of ETFs and the corresponding indexes. We
take into account the absolute value of return differences because either a positive or a
negative difference reflects a performance deviation. This estimation is expressed in
model (5):
n

2, =

e pt

t =1

(5)

where e Pt is the absolute return difference in day t.

Finally, the third method, 3,, computes the standard deviation of return
differences between ETFs and their indexes. The estimation of this tracking error is
presented in equation (6):
3, =

1
n 1

(e
t =1

pt

ep )2

(6)

where e pt is the return difference in day t and e p is the average return difference over n
days.
We should note that the investing strategy of active ETFs concerns the
outperformance of the market while the passive ETFs aim at replicating the market. As
a result, the tracking error of active ETFs should be higher than this of passive ETFs. In
addition, we note that tracking error is basically an efficient performance comparison
among passively managed investing products but it is applied to actively managed
funds too.

3. Data and Descriptive Statistics

Active ETFs were first introduced in the U.S. market on April 30, 2008 by
PowerShares. More specifically, Powershares launched 4 active ETFs. On the other
hand, the history of passively managed ETFs is much longer. The first passive ETF
listed in AMEX in early 90s was the SPDRS which track the performance of the
Standard and Poors 500 Index. Currently, there are five active ETFs available in the
U.S. market.
Our sample consists of three active ETFs and three corresponding passive ETFs
that in pairs have the same index of reference. More specifically, our active ETFs are
the Active AlphaQ Fund, Active Alpha Multi-Cap Fund and the Active Low Duration
Fund. The first active ETF rate companies with more than $400 million market
capitalization traded in the United States. Weekly, the Fund's Sub-Adviser generates a
master stock list that ranks these stocks based on its proprietary methodology. Stocks
are selected based on factors such as strong earnings growth, low valuations and
positive money flow. Fund managers then define their universe as the 100 largest
Nasdaq-listed Global Market Securities from the master stock list. The manager of the
second active ETF of the sample adopts the same investing approach but he defines his
investing choices from the 2,000 largest stocks of companies with varying
capitalizations from his list. Finally, the third active ETF invests at least 80% of its
assets in a portfolio of U.S. government, corporate and agency debt securities. The fund
is limited to 25% of its total assets in non-investment grade securities. Under normal
market conditions, the fund's effective duration will be in the range of zero to three
years. The corresponding benchmarks are the Nasdaq 100 Index, Russell 3000 Index
5

and the Barclays Capital 1-3 Yr US Treasury Index. The respective passive ETFs are
the Powershares Trust Series 1, the iShares Russell 3000 Index Fund and the iShares
Barclays 1-3 Year Tr. BF. The main strategy of these passive ETFs concerns the
investing in indexes components to the same weightings and rebalances whenever it is
necessary due to changes to indexes holdings.
We should point out that PowerShares report the returns of their ETFs with
respect both to the returns of their own benchmarks and the returns of the Standard and
Poors 500 Index. Therefore, we alternatively use this index as a proxy for the U.S.
stock market so as to additionally compare the returns of active ETFs to the returns of
the market.
We gathered our data by several resources. In particular, the trading prices of
active ETFs were supplied from yahoo.finance, the prices of passive ETFs were
collected from Nasdaq.com. Nasdaq.com also provided us with the closing prices of
Nasdaq 100 Index and Standard and Poors 500 Index. Finally, we gathered the
historical data of the rest two indexes from iShares.com.
Table 1 presents the descriptive statistics of ETFs and indexes. More
specifically, the table presents the average and median daily returns, the standard
deviation of returns along with the minimum and maximum returns occurred during the
studying period. The results indicate that the equity active ETFs underperform both
their benchmarks and the corresponding passive ETFs and they also underperform the
Standard and Poors 500 Index. In contrast, the bond active ETF outperforms its
passive counterpart but not the benchmark. Moreover, the results show that the actively
managed ETFs are riskier either than the passive ETFs or the benchmarks. Overall, the
results demonstrate that the active ETFs fail to deliver higher returns than the passive
investing products or the market indexes while they load investors with greater risk.

4. Empirical Results

4.1 Regression Results in Explaining Risk-Adjusted Performance

The regression results for the risk-adjusted performance are presented in Table 2.
Included in the table are the value of Jensens alpha which stands for the risk-adjusted
return, the beta coefficient of each ETF, t-statistics which evaluate the statistical
significance of the estimates, R-square values and the number of observations.
According to the results, both active and passive ETFs do not produce any
material above-normal return. The alpha estimates of each active or passive ETF is
negative while the statistical significance of the estimates is poor. Particularly, there are
two significant alpha estimates. The first one concerns the regression of the first active
ETFs return on the return of the S&P 500 Index. This coefficient is significantly
negative at the 10% level indicating that the specific ETF offer investors negative
excess return with respect to the market return. The other significant alpha estimate
relates to the third passive ETF investing in the Barclays Capital 1-3 Yr US Treasury
Index. This alpha coefficient is negative and significant at the 10% level indicating that
this ETF achieves significant underperformance in relation to the benchmark return.
Overall, the results suggest that the ETFs follow the market return failing to
produce any significant abnormal returns. In fact, since the alpha estimate of the
benchmarks is a priori zero, we ascertain that both the active and passive ETFs perform
worse than the indexes. These findings were expectable for the passive ETFs, whose
effort to replicate the index return is negatively affected by factors such as the
expenses. However, the findings contradict the main assertion of active ETFs which are
6

expected to beat the market offering investors above the average returns. Our results are
in line with the relevant findings of the literature about the U.S. mutual funds [see,
Blake, Elton and Gruber (1993), Malkiel (1995), Gruber (1996)]. Interpreting results as
an indicator of markets efficiency, we perceive that the U.S. ETF market is efficient
enough offering managers low or no chances of gaining irregular returns. Considering
the results as an indicator of the selection skills of the active ETF managers, the
negative alpha estimates show that these managers either fail to diversify properly the
portfolios they manage or fail to add value for investors by detecting and picking stocks
that are undervalued. However, we should point out that the study covers a period that
is characterized by the dramatic financial distress, market crisis and prices volatility.
These features should make us be very sceptic when judging about the skills of the
active ETF managers.
Considering beta estimates, the beta of the first active ETF is significantly lower
than the unity. This pattern applies when we regress the performance of the ETF either
on the return of its own benchmark or on the performance of the S&P 500 Index. On
the other hand, the beta estimates of the passive ETFs are higher and closer to the unity.
These results indicate an investing conservatism for the first active ETF with respect to
the market and the passive ETF competitor.
Considering the beta coefficients of the second pair of active and passive ETFs,
the results in Table 2 show that the beta of the active ETF is higher than the beta of the
passive counterpart being simultaneously statistically indifferent from the unity. In this
case, the active ETF is more aggressive than the passive one. Finally, the beta of the
bond active ETF is significantly lower than the unity and inferior to the beta estimate of
the corresponding passive ETF. Therefore, the third active ETF is less aggressive than
the market and its passive counterpart.
We should note that theoretically, conservatism helps funds to be less sensitive
to the market movements protecting them in a bear market but it restrains them in a bull
market. This means that funds return declines less than benchmarks return when the
market goes down but funds return ascends slowly in comparison to indexes return
when the market moves upwards. However, this theoretic aphorism is not empirically
verified by the results of our study since in the current bear market the conservatism of
active ETFs indicated by the results (in two of three cases) does not prevent them from
declining more with respect to the market returns.

4.2 Results in Rating Performance

In this section we present the rating of ETFs and indexes performance according to the
total return for the period, the Sharpe ratio, the Treynor ratio and the Jensens alpha.
The results are presented in two sub-panels in Table 3. The first panel presents the
ratings of ETFs with respect to their own benchmarks while the second one presents the
ratings of ETFs in regards of the ratings received by the S&P 500 Index.
The ratings confirm the underperformance of the active ETFs relative to the
passive ETFs and the indexes described in the previous two sections. More specifically,
Panel A reports that the ratings of any type assigned to the first active ETF are inferior
to the ratings given to the passive ETF competitor and the Russell 3000 Index. This is
the case for the second active ETF too. Considering the third active ETF, its rating is
inferior to the rating of the benchmark and basically superior to the rating of the passive
ETF (but not in terms of Treynor ratio).
Panel B reports that the rating of equity ETFs, both the active and the passive
ones, is basically inferior to the rating of the S&P 500 Index. Regardless the rating
method, the performance of ETFs is assigned lower rating in comparison to the indexs
7

rating. Considering the bond ETFs, we see that these ETFs achieve positive total returns
during the studying period while the rates they receive in accordance to the Sharpe and
Treynor ratios are positive. Comparing the equity and bond investing instruments, we
see that investors could replace their equity holdings with bond ones so as to mitigate
the losses from the rapid and deep decline in stock markets during the period we assess.

4.3 Regression Results in Testing Market Timing

This section discusses the estimations of the Treynor and Mazuy 1966 model (4) which
evaluates the market timing skills of ETF managers. The regression results are
presented in Table 4. Presented in the table are the values of alpha, beta and gamma
coefficients, the values of the relevant t-statistics, the R-squares and the number of
daily trading observations available for each ETF. The gamma coefficient assesses the
market timing skills of the managers. Positive and significant gamma estimates indicate
that the managers efficiently time the market. Negative or insignificant gamma
estimations imply that the ETF managers are lacking in sufficient market timing skills.
Moreover, we note that the model mainly applies to active ETFs since passively
managed ETFs are not supposed to time the market.
According to the results in Table 4, the active ETF managers do not possess any
significant market timing skills. The gamma estimates of the applied model are either
positive or negative but insignificant at any acceptable level. For the equity active
ETFs, the finding of non-existent timing skills for the managers applies either when we
use the specific benchmark of each ETF or the S&P 500 Index.
Considering the results for the passive ETFs, the gamma estimates do not differ
statistically from zero when the benchmarks returns are used as a proxy for the market
performance. Interestingly, when the S&P 500 Index is used as the market performance
the model derives statistically significant gamma estimations for passive equity ETFs.
The estimate for the first ETF is positive and the estimate for the second one is
negative. However, their values (0.010 and -0.003 respectively) is not considerably
different from zero.
Focusing on the active ETFs, the results of the applied model demonstrate that
their managers failed to predict the depth of the unexpected financial crisis and adjust
accordingly their investing decisions. Overall, our results are consistent with the
previous findings of Treynor and Mazuy (1966), Henriksson and Merton (1981), Chang
and Lewellen (1984), Henriksson (1984), Graham and Harvey (1996) on the time
abilities of active mutual fund managers. All of these studies report restricted on nonexistent market timing ability for mutual fund managers. The common feature of these
studies is that the returns are considered on a monthly or an annually basis while, in our
study, returns are considered daily. Therefore, our findings are more comparable to the
results of Bollen and Busse (2001) and Chance and Hemler (2001). These authors apply
daily tests on the market timing efficiency of mutual funds revealing that the managers
possess material market timing skills. However, this inference does not apply to active
ETF managers, at least according to our results.

4.4 Results in Estimating Tracking Error

The last segment of the paper presents the estimations of ETFs tracking error.
Tracking error denotes the difference in returns of ETFs and indexes. Tracking error
calculations are presented in Table 5. The first three columns show the results of each
one of the three types and the fourth column is the average tracking error of the three
alternative estimates.
8

The results show that the tracking error of active ETFs is higher than that of the
passively managed ETFs. This pattern applies both to the return comparison between
ETFs and their assigned indexes of reference and the performance differences between
ETFs and the S&P 500 Index. Considering the individual equity active ETFs, the
maximum average tracking error concerns the Active Alpha Multi-Cap Fund, which
tracks the Russell 3000 Index. The magnitude of the average tracking error of this ETF
is equal to 1.753. On the contrary, the corresponding passive ETF presents lower
tracking error relative to the QQQQ which tracks the Nasdaq100 Index. The maximum
average tracking of QQQQ is equal to 0.344. Comparing the equity ETFs to the bond
ETF, the results indicate that the tracking error estimates of the bond ETF is
significantly lower than the tracking errors of the equity ETFs. This finding applies
either to active or passive ETFs and it is reasonable since in general bond ETFs are less
risky and expensive than equity ETFs and they consequently derive lower tracking
errors in relation to equity ETFs.
Overall, the fact that the active ETFs produce higher tracking error relative to
the passive ETFs is a reasonable and expectable finding since the active ETFs aim at
beating the market returns rather than replicating them.

5. Summary and Conclusions

The ability of mutual fund managers to beat the market by applying efficient selection
and market timing strategies has been thoroughly examined by the literature. The
findings on this issue are ambiguous, which means that there are studies that report
material outperformance of actively managed mutual funds with respect to the market
returns but there are also studies that demonstrate that the active mutual funds basically
underperform the market indexes and the passively managed index funds. In this paper,
we expand the research on the active vs. passive management debate by providing
new evidence from U.S. listed ETFs.
The results of our study are summarized as follows: At first, considering the raw
return we find that the active ETFs basically derive lower percentage returns than the
passive ETFs and the market indexes. Simultaneously, the active ETFs are found to be
more risky than the passive counterparts and the benchmarks. Considering risk-adjusted
performance expressed by Jensens alpha, we find no evidence that the active ETF
managers achieve significant excess returns with respect to the average market returns
and risk-adjusted performance of the passively managed ETFs, which are not supposed
to deliver any excess return anyway. The underperformance of active ETFs is also
depicted to the lower ratings (total return and Sharpe and Treynor ratios) they receive
relative to the indexes and passive ETFs.
The findings about risk-adjusted performance may suggest that the U.S. ETF
market is efficiently enough providing managers with no significant opportunities for
gaining abnormal returns. On the other hand, the results can be interpreted as an
indicator for the managers lacking in selection skills. This indicator implies that the
active ETF managers fail to detect and select the stocks that are undervalued. However,
we should bear in mind that the unprecedented crisis in stock markets worldwide
impoverishes the investing choices on the managers.
Considering the market timing abilities of ETF managers, the results indicate
that managers are not able to time the market efficiently. In regression analysis, we find
that market timing coefficients ( estimates) are basically negative and insignificant.
While passive ETF managers are simply follow the market without trying to time it, the
active ETFs are supposed to time the market efficient so as to help the portfolios they
9

manage to outperform the market return. Therefore, our findings indicate that the active
ETFs fail to do what they are required to. Moreover, the lack of market timing skills
may contributes to the failure of active ETFs to achieve significant abnormal returns.
Finally, with respect to the tracking ability of ETFs, we find that the active ETFs
have greater tracking error than the passive ones. However, the active ETFs do not aim
at replicating the market returns and therefore the findings are reasonable.
Overall, our empirical results about the performance of the active and passive
ETFs are in line with the previous findings of the literature on the performance of active
mutual funds. The lack of significant risk-adjusted performance for active ETFs due to
inadequate selection and market timing skills support the existing literature on mutual
fund performance and managerial behavior with a new set of data having different
operating characteristics.

10

References
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Funds, Journal of Business 66 (3), pp. 371-403.
Bollen, N.P., and Busse, J.A., 2001, On the timing ability of mutual fund Managers,
Journal of Finance 56, pp. 1075-1094.
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11

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of Finance 54 (2), pp. 581-622.

12

Table 1
Descriptive Statistics
This table reports the mean and median daily return, the standard deviation and the minimum and maximum return, ratio of
active ETFs, passive ETFs, benchmarks, Standard and Poors 500 Index, the SPDRS which track the S&P 500 Index
(passively managed ETF) and the risk-free rate during the period 05/01/2008- 11/28/2008.
Active ETF
Passive ETF
Index

Names
Active AlphaQ Fund
Powershares Trust Series 1
NASDAQ 100 Index

Symb.
PQY
QQQQ

Mean
-0.295
-0.286
-0.280

Median
0.000
-0.269
-0.194

Stdev
3.041
2.834
3.009

Min
-10.412
-8.956
-10.519

Max
13.571
12.165
12.580

Obs.
148
148
148

Active ETF
Passive ETF
Index

Active Alpha Multi-Cap Fund

iShares Russell 3000 Index Fund
RUSSELL 3000 Index

PQZ
IWY

-0.388
-0.258
-0.259

0.000
-0.052
-0.031

3.613
2.857
2.970

-12.375
-9.072
-9.143

13.919
10.429
11.475

148
148
148

Active ETF
Passive ETF
Index

Active Low Duration Fund

iShares Barclays 1-3 Year Tr. BF
Barclays Capital 1-3 Yr US Tr. In

PLK
SHY

0.019
0.012
0.026

0.000
0.036
0.035

0.703
0.193
0.197

-2.564
-0.561
-0.913

2.863
0.712
0.761

148
148
148

Index

S&P 500 Index

-0.253

-0.016

2.869

-9.035

11.580

148

13

Table 2
Performance Regression Results
Rp,i-Rf = p,i + p,i(Rm-Rf) + p,i
This table presents the results of performance regression. We regress the risk-adjusted daily return of ETFs on the riskadjusted daily return either of their benchmarks or the Standard and Poors 500 Index. Ri is the return of ETFs, Rf is the riskfree return and Rm denotes the markets return. T-tests for alpha and beta coefficient evaluate the difference of the estimates
from zero and unity respectively. *Statistically significant at the 1% level. **Statistically significant at the 5% level.
***Statistically significant at the 10% level.
Active ETF
Passive ETF
Active ETF
Passive ETF

Symb.
PQY
QQQQ
PQY
QQQQ

Underlying
NASDAQ 100 Index
NASDAQ 100 Index
S&P 500 Index
S&P 500 Index

-0.085
-0.005
-0.123***
-0.071

t-test
-1.349
0.003
-1.936
-0.847

0.781*
1.003
0.729*
0.882*

t-test
-5.111
0.271
-3.552
-3.209

R2
0.720
0.989
0.619
0.806

Obs.
148
148
148
148

Active ETF
Passive ETF
Active ETF
Passive ETF

PQZ
IWY
PQZ
IWY

RUSSELL 3000 Index

RUSSELL 3000 Index
S&P 500 Index
S&P 500 Index

-0.103
-0.008
-0.128
-0.014

-0.882
-0.994
-0.873
-0.672

1.061
0.973**
0.992
0.977

0.821
-2.483
-0.115
-1.299

0.741
0.994
0.605
0.931

148
148
148
148

Active ETF
Passive ETF

PLK
SHY

Barclays Capital 1-3 Yr US Tr.

Barclays Capital 1-3 Yr US Tr.

0.000
-0.009***

-0.024
-1.665

0.646
0.818*

-1.562
-4.029

0.342
0.701

148
148

14

Table 3
Performance Rating
This table presents the rating of funds and benchmarks performance per group according to total return, Sharpe
ratio, Treynor ratio and Jensens alpha. ***Statistically significant at the 10% level.

Active ETF
Passive ETF
Index
Active ETF
Passive ETF
Index
Active ETF
Passive ETF
Index

Active ETF
Passive ETF
Active ETF
Passive ETF
Active ETF
Passive ETF
Index

Panel A: Rating of ETFs with respect to their benchmarks

Symbols
Total Return
Sharpe
Treynor
PQY
-39.672
-0.097
-0.378
QQQQ
-38.318
-0.101
-0.285
NASDAQ 100 Index
-38.168
-0.093
-0.280
PQZ
IWY
RUSSELL 3000 Index

-48.970
-35.788
-36.133

-0.107
-0.090
-0.087

-0.366
-0.265
-0.259

PLK
2.503
0.027
0.030
SHY
1.727
0.061
0.014
Barclays Capital 1-3 Yr US Tr.
3.841
0.130
0.026
Panel B: Rating of ETFs with respect to the S&P 500 Index
Symbols
Total Return
Sharpe
Treynor
PQY
-39.672
-0.097
-0.405
QQQQ
-38.318
-0.101
-0.325
PQZ
-48.970
-0.107
-0.391
IWY
-35.788
-0.090
-0.264
PLK
2.503
0.027
N/A
SHY
1.727
0.061
N/A
S&P 500 Index
-35.317
-0.088
-0.253

15

Jensen
-0.085
-0.005
0.000
-0.103
-0.008
0.000
0.000
-0.009***
0.000
Jensen
-0.123***
-0.071
-0.128
-0.014
N/A
N/A
0.000

Table 4
Market Timing Regression Results
Rp,i-Rf = p + p(Rm-Rf) + p,i(Rm-Rf)2 + p,i
This table reports the results of regression which evaluates the timing ability of ETF agers. Ri is the return of funds, Rf is
the risk-free return and Rm denotes the markets return. T-test counts for the statistical significance of coefficients. The
timing ability implies that the managers respond efficiently to the movements of the stock market and revise the
portfolios they manage. The timing ability is assessed via the regressions gamma estimate. *Statistical significant at the
1% level. **Statistically significant at the 5% level. ***Statistically significant at the 10% level.
Symb.
PQY
QQQQ
PQY
QQQQ

Underlying
NASDAQ 100 Index
NASDAQ 100 Index
S&P 500 Index
S&P 500 Index

-0.107
0.002
-0.136***
-0.157

t-test
-1.398
0.799
-1.712
-1.602

0.780*
1.001*
0.728*
0.872*

t-test
18.122
122.47
9.363
23.339

0.002
-0.001
0.002
0.010***

t-test
0.511
-1.760***
0.188
1.827

R2
0.721
0.989
0.619
0.810

Obs.
148
148
148
148

PQZ
IWY
PQZ
IWY

RUSSELL 3000 Index

RUSSELL 3000 Index
S&P 500 Index
S&P 500 Index

-0.089
0.004
-0.117
0.008

-0.862
0.624
-0.694
0.367

1.068*
0.973*
0.994*
0.976*

14.381
91.877
15.067
57.874

-0.003
-0.001
-0.001
-0.003***

-0.274
-1.591
-0.133
-1.748

0.752
0.994
0.605
0.934

148
148
148
148

PLK
SHY

Barclays Capital 1-3 Yr

Barclays Capital 1-3 Yr

-0.013
-0.011***

-0.497
-1.784

0.658**
0.820*

2.035
17.988

0.319
0.054

0.396
0.700

0.346
0.702

148
148

16

Table 5
Tracking Error Results
This table presents the estimations of tracking rrror, which reflects the deviation between the return of ETFs and
their underlying indexes. We apply three distinct methods in tracking error estimating, labeling them as 1,
2, and 3. TE1 is the standard deviation of return differences between ETFs and indexes. TE2 is the absolute
average return difference between ETFs and indexes. TE3 is the standard errors of ETFs performance
regression.
Symbol

TE1

TE2

TE3

NASDAQ 100 Index

NASDAQ 100 Index
S&P 500 Index
S&P 500 Index

2.022
0.482
2.401
1.312

1.249
0.232
1.430
0.812

1.643
0.318
1.919
1.254

Average
TE(1+2+3)
1.638
0.344
1.917
1.126

PQZ
IWY
PQZ
IWY

RUSSELL 3000 Index

RUSSELL 3000 Index
S&P 500 Index
S&P 500 Index

1.941
0.309
2.372
0.983

1.461
0.186
1.616
0.329

1.857
0.232
2.294
0.777

1.753
0.242
2.094
0.696

PLK
SHY

Barclays Capital 1-3 Yr

Barclays Capital 1-3 Yr

0.743
0.127

0.413
0.084

0.589
0.106

0.582
0.106

PQY
QQQQ
PQY
QQQQ

Underlying

17