Index ETFs' Tracking Error as a Predictor of Performance

We find that index ETFs' tracking error, a measure of the manager's ability to replicate the index's return, is a significantly and consistently negative predictor of performance. Tracking error is highly persistent, indicating index ETF manager's ability to replicate the index persists over time. We find that the performance predictability of tracking error comes mainly from index ETFs with higher tracking errors. Despite tracking error being a performance predictor, investors' flow is insensitive to tracking error. Investors have limited information processing capacity, face information inertia, and have restricted access to index ETFs, thus not optimally chasing index ETFs with lower tracking errors. Our long-only trading strategy that buys S&P 500 index ETFs with lowest-quintile tracking errors outperforms the equal-weighted portfolio of all S&P 500 index ETFs by 1.89% annually over 2003-2021