Exchange-traded funds: An innovative way to diversify portfolios maximizing returns and/or minimizing risks

This empirical and quantitative study applies Modern Portfolio Theory (MPT) to construct Exchange-Traded Funds (ETF) portfolios and compares the performance of these portfolios against the market---the S&P 500 index The performance measurement is the Sharpe ratio---the return per unit of risk.;The rationale for this study was the recent flaws of corporate governance (late-trading and market-timing) and the average in efficient portfolios of the mutual fund industry. The study's outcome provides some insight into the traditional investment dilemma of investing in portfolios with ETF securities or in a market asset indexed to the S&P 500 index.;ETF is a fairly new security and the first one, Standard & Poor's Depositary Receipt (SPDR), was launched in 1993. It combines the advantages of indexing with those of stock trading. As of December 30, 2005, there were 203 ETF with net asset value (NAV) of US;Six hypotheses have been tested using efficient ETF portfolios. The dependent variables were the portfolios and market total return and risk. The independent variables were the market factors (expected market return and risk free rate), the ETF statistical data for the previous three years, and the weights of each ETF in the efficient portfolio.;ETF portfolios by market capitalization, value-index, international, global and global rebalanced quarterly showed statistically better performance than the market during 2006. The only exception was the ETF portfolio by industries. Additionally, the study found that rebalancing had a positive effect on the portfolio's performance.;The use of MPT to construct and periodically rebalance portfolios is likely to provide positive and quantifiable performance benefits. Therefore, MPT is a valid theory and a good tool to build more efficient portfolios than the market, when market is defined as the S&P 500 index.