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The founder of the investment portfolio theory Harry Markowitz created a first portfolio model and calculated expected rate of return for the assets included in it with expected risk measure, Markowitz (1952, 1959).  In his remarkable research the author proved that the variance of the rate of return was a meaningful measure of the risk of the portfolio under several assumptions regarding investor behaviour.

The theory states that“..a single asset or portfolio of assets is considered to be efficient if no other assets offers higher expected return with the same (or lower) risk or lower risk with the same (or higher) expected return”, Brown/Reilly,(2009).

Harry Markowitz’s portfolio theory was further developed by the Nobel Prize laureate William Sharpe by introducing risk-free asset, which is an asset with zero variance and zero correlation with all the other risky assets. The return which the risk-free asset provides is deemed to be the risk-free rate of return.

With their research Sharp(1964) and later Linter(1965) and Mossin(1966) independently developed the portfolio theory of Markowitz  into Capital Market Theory. The latter states that a rational investor should only buy assets of two types: the risk free securities and the risky asset, so called market portfolio-the single collection of all risky assets held anywhere in the marketplace.

Such a portfolio is considered to receive the highest level of expected return per unit of risk in excess of the risk-free rate than any other portfolio. The portfolio must include not just US common stocks and bonds, but also the non-US ones, real estate, private equity, derivatives, art, etc. The weights are only defined by the investor’s tolerance for risk. Market Portfolio is also completely diversified since containing all the risky assets it fully eliminates unsystematic risk, i.e. a unique variability of any single asset included in the portfolio.

The only risk remained is the un-diversifiable, or systematic risk, i.e. the variability in all the risky assets of the portfolio. Caused only by the macroeconomic variables, systematic risk is measured by the standard deviation of returns to the market portfolio. Changes in money supply, countries’ GDPs, interest rates, corporate earnings might both positively and negatively influence the systematic risk.

All the portfolios on the Capital Market Line (CML) considered to be perfectly correlated with the Market Portfolio and according to Lorie (1975) will have a correlation “score” +1.00, which means that all the unsystematic risk has been completely eliminated. A number of academic researches has been undertaken in order to define the number of individual stocks to be included in the portfolio to achieve maximum benefits of diversification.

Evans and Archer (1968) and Tole (1982) studied the standard deviation of a portfolio of up to 20 stocks. They found that about 90% of maximum benefits were achieved from the portfolio of 12 to 18 stocks. Statman (1987) studying the trade-off between transactional costs and diversification benefits arrived to the optimal number of the stocks as many as 30-40.

The first ETF was created and launched in 1993 by the American Stock Exchange (Amex) which used the Securities and Exchange Commission's (SEC) "SuperTrust Order" to first authorize stand-alone index based exchange-traded fund (ETF). The AMEX’ petition had been approved by the SEC and the S&P Depository Receipts Trust Series 1, or "SDPRs", was released and quickly gained acceptance in the marketplace to become the first commercially successful ETF in history. The First European ETFs emerged in 2000 with their popularity growing exponentially.

Creation of such an investment vehicle was the investment industry’s response to the pricing problem investors encountered in mutual funds in general and in index funds in particular. These vehicles were only priced daily at the markets’ closer time, which made possible only to buy and sell the funds ones a day at the closing prices. Needless to say how important it is to be able to make any transactions as a response to the rapidly changing market environment, incoming political and economic news, events, etc.

Also referred to as listed mutual funds, ETFs could follow both passive: long index and active: long/short and leverage strategies, take exposure in equity, fixed income, commodities (diversified indices), derivatives, currencies, etc.This was exactly the opportunity, which would be impossible to overrate, the new continuously trading, liquid, low execution costs’ investment vehicle- ETFs provided investors with.

One of the industry’s pioneers Barclays’s Global Investors (BGI) utilized Morgan Stanley Capital International Indexes (MSCI) to create i-shares, ETFs for a number of different countries, industries’ indexes which are currently widely used by both international institutional and private investors. BGI have been followed by a number of portfolio and asset managers from biggest international banks to small investment companies in order to create an entire universe of the ETFs which will be analysed later on in the dissertation.

“All investors are Markowitz-efficient in that they seek to invest in tangent points on the efficient frontier”, assumption of Capital Market Theory, Brown/Reilly, 2009.

The advent of ETF industry was consistent with becoming more and more popular passive portfolio management style. As Gastineau (2002) points out in his article, the first indexed portfolio was created and launched by Wells Fargo for a single pension fund client. In 1973, Wells Fargo organized and commingled a fund for trust accounts and in 1976, the funds were combined and the capitalization-weighted S&P index was used as a sample for the combined portfolios.  The first broad-market index fund for retail investors was launched by the Vanguard manager John Bogle in 1975.

There were some academic research and publications, such as “A Random walk Down the Wall Street” by Malkiel, B. (1973): “What we need is a no-load, minimum-management fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages”, Samuelson, P. (1974):”The only honest conclusion is to agree that a loose version of the “efficient market” or “random walk” hypothesis accords with the facts of life”,  Ellis, C. (1975) who argued that the average institutional investor would typically underperform  the market as measured by representative index. Questioning the performance of the fund managers and their fees these ideas prompted the development of indexing.  

Theoretical basis for the passive style of portfolio management was laid by the prominent academic work of Fama(1970), Fama (1991 and 1998) who undertook extensive empirical analysis, organized a vast evidence to present the Efficient Market Hypothesis (EMH) or a fair game model. The EMH states that the current market price fully reflects all available to the market participants information about an asset (e.g. security) and consequently, the return based upon this price is consistent with its risk.

Three forms of the market efficiency: weak, semi-strong and strong, were described by Fama. The EMH argues that no investors will be able to consistently derive above average risk-adjusted rates of return, as under the strong-form of the EMH, prices almost immediately adjust to the release of new public information. It is assumed that the information is available to everyone and is cost-free, i.e. the markets are perfect.