Isaac Newton’s third law of motion states that for every action there is an equal and opposite reaction. Never in my professional career had I imagined that a physics-related concept would motivate me to undertake a research project aimed at explaining the performance of index funds!

The popularity of indexing and ETFs has ignited a newfound emphasis on index fund due diligence. The most common due diligence process has been one that provides a list of metrics including—but not limited to—expense ratio, excess return, and assets under management and that then requires investors to pick through those metrics to determine whether or not the index fund is any good.

This approach never made sense to me for these two reasons:

  1. Investors should start by first measuring excess return and tracking error when gauging an index fund’s ability to track its index.
  2. Investors should then view the other often-cited metrics as potential causes of excess return or tracking error.

In other words, investors shouldn’t necessarily look at expense ratio and excess return independently because expense ratio has a direct impact on excess return. Put in Newtonian terms, the action of a fund charging an expense ratio causes the reaction of a lower excess return.

The research analyzes the effect that several “action” variables have on the two “reaction” variables of excess return and tracking error, and because the sample consists of ETFs, excess return and tracking error are analyzed on both a net asset value and a market price basis. Admittedly, it’s not the case that every action causes exactly an equal and opposite reaction, but it is the case that expense ratio is the dominant variable that explains excess return and that active share is one of the statistically significant variables that explains tracking error.

I won’t give away all the conclusions, but you can read about them in The Journal of Portfolio Management. If Newton were alive today and an indexer, I hope he would find the analysis useful when trying to select index funds. I hope you do as well.

Notes:

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