Portfolio Choice with ETFs

35 Pages Posted: 18 Jan 2024

See all articles by Tom Ernst

Tom Ernst

Goethe University Frankfurt

Holger Kraft

Goethe University Frankfurt

Claus Munk

Copenhagen Business School

Date Written: January 8, 2024


The modern portfolio theory of Markowitz and Merton prescribes that investors should combine a riskfree asset with a portfolio of all risky assets. The latter is often implemented by holding an ETF tracking a stock market index like the S&P 500. We identify three issues with this practice. First, physical ETFs only hold a subset of the stock market and may not combine the assets in the way that is optimal for investors. Second, some ETFs are synthetic and come with counterparty risk. Third, most stock market indices---and ETFs tracking those indices---are not counter-cyclically rebalanced to maintain constant weights over time, which is what the optimal Merton strategy dictates. We quantify the impact of these issues on investor welfare and propose better solutions.

Keywords: Physical ETFs, synthetic ETFs, investor welfare, background risk, counter-cyclical investment

JEL Classification: G11, G51, D15

Suggested Citation

Ernst, Tom and Kraft, Holger and Munk, Claus, Portfolio Choice with ETFs (January 8, 2024). Available at SSRN: https://ssrn.com/abstract=4687259 or http://dx.doi.org/10.2139/ssrn.4687259

Tom Ernst

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323

Holger Kraft

Goethe University Frankfurt ( email )

Faculty of Economics and Business
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323

Claus Munk (Contact Author)

Copenhagen Business School ( email )

Department of Finance
Solbjerg Plads 3
Frederiksberg, DK-2000

HOME PAGE: http://sites.google.com/view/clausmunk/home

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