The Potential for Exchange Traded Funds
Previous research provides evidence that much of the cross-sectional variation in equity returns can be explained by firm characteristics or sectors such as market capitalization, price-to-earnings ratios, change in operating earnings, and book-to-market ratios. Some of the newest equity investment vehicles these days are exchange-traded funds, or ETFs. These funds trade very closely to the value of the underlying stocks in the portfolio and are generally categorized by indexes or sectors that they track. This study demonstrates the potential for portfolio return enhancement when portfolio optimization techniques are employed on subsets of a broader population of stocks that are grouped according to sectors similar to those that catagorize ETFs. Specifically, ex ante optimization over portfolios formed on the basis of decile classifications of market capitalization, price-to-earnings ratios, change in operating earnings, and book-to-market ratios demonstrates significant potential for enhancing overall equity portfolio returns relative to value-weighted and equal-weighted benchmark portfolios constructed from the population of stocks from which the characteristic portfolios are formed.