Mispriced and Misunderstood? The Impact of Liquidity on Tracking Errors in European ETFs

Sammanfattning

This thesis investigates how liquidity affects tracking errors in European passive ETFs. To examine this relationship, we apply panel regressions with fixed effects and double-clustered standard errors, controlling for return volatility and fund characteristics. Based on a sample of 494 ETFs from 2000 to 2024, we find that lower liquidity - measured by the relative quoted half spread - is strongly associated with higher pricing-based tracking errors, particularly weakening the price alignment between ETF market prices and their Net Asset Values (NAVs). This finding supports earlier evidence while extending it to the European ETF market. In contrast, tracking errors between NAVs and benchmark indices appear less sensitive to liquidity. The results highlight the importance of market liquidity for ETF pricing efficiency and underscore the challenges posed by Europe's fragmented trading landscape.