Analysis of the Performance of ETFs. A study on the US market

Abstract: Exchange Traded Funds are known as a relatively recent financial innovation and have been gaining investors' interest in recent years. The performance of ETF in comparison to other benchmarks is still the central concern when investors make an investment decision. This thesis conducts empirical studies in the US market, using the Mean-Variance portfolio optimization, to construct optimal portfolios for both ETFs and underlying assets with and without short-selling constraints to compare these two portfolios based on historical and expected performance. The performance of individual ETFs and their underlying assets during the whole testing period and different downturns is analyzed before portfolios are constructed. The thesis then applies Fama and French three-factor model to assess the portfolios’ risk-adjusted returns. Finally, different financial metrics are used to evaluate the portfolios' performance. The empirical results show that if not taking the cost-efficiency and high liquidity characteristics of ETF into account, the ETF portfolio often underperforms the underlying asset portfolio. Besides, with the short-selling constraint, the ETF portfolio also underperforms the market portfolio in the testing period. However, if those advantages of ETF are taken into consideration and if short-selling is allowed and used as an effective hedging tool, the ETF portfolio might outperform these benchmarks.