Information Inertia and Limited Information Processing Capacity in Selecting Index ETFs

We investigate the role of information inertia and limited information processing capacity in creating an anomaly in the US index ETF industry. We fi nd that tracking errors and long-term returns are significant and consistent predictors of future returns, while there is little evidence that investors' flows are sensitive to them. In line with this finding, we provide a trading strategy that chases small tracking errors, which outperforms the equal-weighted portfolio of all S&P 500 index ETFs by 1.65% annually over 2003-2020. Mutual fund managers who just joined the fund are more likely to switch to better index ETFs than existing managers, suggesting investors face information inertia. Unsophisticated investors have limited information processing capacity as index ETFs held by more institutional investors deliver higher returns. Overall, our results suggest that the anomaly in low-return and low-tracking error sensitivity in the index ETF industry can be explained by information inertia and limited information processing capacity.