Portfolio Choice with ETFs: Pitfalls and Progress

Abstract

The Markowitz-Merton portfolio theory prescribes that investors combine a riskfree asset with a portfolio of all risky assets. We identify four issues with implementing this through a stock market index ETF. First, physical ETFs hold only a subset of the market and may not weight the stocks as investors prefer. Second, some ETFs are synthetic and come with counterparty risk. Third, most stock indices and ETFs are not rebalanced to maintain constant weights, in contrast to the optimal Merton strategy. Fourth, mainstream ETFs disregard labor income. We quantify the impact of these issues on investor welfare and propose improvements.

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

JEL Classification: G11, G51, D15