Index funds and exchange traded funds; Substitutability and reasons for the coexistence

Abstract

This research studies the substitutability and reasons for the coexistence of two similar investment vehicles, conventional index funds and exchange traded funds (ETFs), in the Korean market. The major findings of this study are as follows. First, ETFs and conventional index funds generally track their underlying indexes closely and the mean of tracking errors are not statistically different. Second, cash flows to one type of fund do not affect the cash flows of the other, indicating that conventional index funds and ETFs are not substitutes for each other. Third, the coexistence of ETFs and index funds can be explained by the behavior of fund investors who prefer different characteristics of these funds.