This paper evaluates the performance and trading characteristics of Exchange Traded Funds (ETFs) using a sample of 73 iShares. It also investigates the ability of iShares to accurately replicate the performance of their underlying indexes and finds that they fail to do so. In addition, the study finds that this failure is greater for iShares tracking the international capital indexes of Morgan Stanley. The results reveal that iShares trade at a premium to their net asset value. Considering the determinative factors of tracking error, the study finds that it is strongly affected by expenses and risk and provides evidence that it is induced by the premium and the trading activity of iShares. Premium is found to be positively affected by tracking error and negatively by volume. Further, regression analysis indicates that the lagged premium is indicative of future return. The study also provides evidence that the volume is positively affected by the intraday price volatility of iShares.

iShares are Exchange Traded Funds (ETFs) managed by Barclays Global Investors. However, iShares were not originally introduced by Barclays. The World Equity Benchmark Shares (WEBS) single country funds (the progenitor of iShares) were initially a Morgan Stanley product, with the portfolio managed by Barclays under a sub-advisory agreement. When Barclays entered the ETF business on a large-scale, Morgan Stanley transferred to Barclays the responsibility for the WEBS, which were renamed iShares MSCI Series upon the transfer.

iShares are formed as open-ended index mutual funds. This form is the most common among ETFs. The main characteristic of the mutual fund-like formation of iShares is that they have the ability to reinvest the accumulated dividends immediately. iShares provide investors with the ability to track an entire segment of a sector, broad or international capital market with a single transaction. However, iShares are not fully invested in the securities of the underlying indexes. According to Zhong and Yang (2005), a combination of money market instruments—option and future contracts, stock index swaps, cash and forward currency exchange contracts—comprise the 5% of each iShare portfolio.

Applied Finance Journal, Exchange Traded Funds, ETFs, World Equity Benchmark Shares, WEBS, International Capital Markets, Money Market Instruments, Net Asset Value, NAV, Indicative Optimized Portfolio Value, IOPV, Global Sectors, Global Asset Allocation Strategies, Close-end Country Funds, CEFs, Dynamic Strategies.