Index investing allows investors to put their money to work with some of the lowest costs in the industry. If low fees for financial services concern you the most, this may be the starting point for your future planning.
New investment products in the last decade allow individuals with relatively smaller portfolios to use ETF’s in order to gain out-sized diversification in a variety of indices. The financial press has widely publicized that typical management fees for index funds are under 20 bips (0.2 percent) which makes them some of the lowest fee choices available. The popular thinking equates greater returns on investment with lowered fees for services.

Other advantages include the fact that shares of the ETF’s trade all day long. This contrasts with many mutual funds whose shares are marked to market once daily, at the close. Sophisticated accredited investors may even short the ETF’s or buy and sell options contracts on them. This flexibility and wide range of choices makes them preferable to mutual fund shares for some purposes.

The wide range of indices represented by ETF’s allow investors or trustees to overweight certain areas which may be more relevant to beneficiaries in a customized manner. A charity involved in food distribution my overweight food related commodities while a company involved in delivery of heavy equipment might overweight energy and transportation issues.

ETF Transaction costs may be significant

The downside to ETF’s is that trading costs may be significant. If you wish to receive monthly income and to re-balance, you’ll need to liquidate shares on the open market regularly. This increases costs to a much greater degree than alternatives which have zero trading costs and zero fees for cash redemption. Individuals may need larger portfolios with less frequent distributions and re-balancing in order to fully realize the cost savings of the lower management fees. In order to take advantage of the great diversification available with ETF’s, a retirement account of at least $2,500,000 starts to make this method economically feasible.

ETF returns under-perform their benchmark

Investors who chase ETF returns make the same mistake that any market timer makes. The design of these instruments allows for out-sized diversification, not out-sized profits. In fact, to the degree that the managers successfully execute the purpose of the fund, they are guaranteed to under-perform their benchmark over each period, simply because of the fee structure and the fact that the underlying assets must conform to the benchmark yields and returns.

The simplistic investment policy statement of ETF’s allows for these low fees. For a given benchmark, the selection of underlying stocks makes the manager’s job easier. One of the largest and most popular index ETF’s is the Dow Jones Industrial Fund (Symbol: DIA) or Diamonds. In order to create shares in this fund, the managers at State Street Bank and Trust Company purchase shares in each of the stocks in the Dow Jones 30 Industrial Index on a capitalization weighted basis. As of this writing, there is somewhat more than 9 billion dollars in the trust and more shares may be created or liquidated in units of 50,000 shares. The procedural details can be found here.

The purpose of the trust is to provide investment results, before expenses that correspond to the price and yield performance of the Dow Jones Index. The managers don’t make any judgments about the individual stock components or any economic, financial or market considerations. They simply make sure that at the end of the day the trust holds enough shares of each individual stock so that one share of the DIA represents an interest in the thirty stocks.

While the Dow Jones Industrial Average may be the most reported index, hundreds of other indices support the diversification needs of individual and institutional investors. The long history of these benchmarks makes for simpler calculations of risk and covariance for professional asset allocators.

Using index funds like ETF's allows for a stringent design of diversification. The investment policy statement of the funds demands that all of the equities in the particular index must be held without regard to valuation or any performance prediction. Thus, the fund follows the performance and yield of the given index very carefully. When an expert designs a diversification plan, she first looks to which investments form a group in some natural way. The first major cut is to distinguish stocks from bonds. Every investor can say why those two are different; it comes down to whether or not the investor owns some of the company or lends some of his money to the company.

This difference makes the two asset classes behave differently when things change in the macro economy. As interest rates rise, some stock prices may go down as the value of bonds comparatively increases. The opposite may happen if interest rates go lower. If you own a combination of stocks and bonds, the individual components will fluctuate, but the total value of your holdings will change less. While it's great to have a bifurcated plan of diversification, an expert can do much better than that.

Logical Groupings Help Create Sub Asset Classes

She looks for logical groupings among stocks that would make them behave in similar manners. Consider that transport, delivery and perhaps car manufacturers behave similarly, although the last may not always move in a pattern similar to the first two.

Contrast those groupings with energy stocks and consumer staples. When energy is expensive, transports and delivery services pay more for gas and report lower profits. Energy companies do well as they achieve pricing power.

Given that this type of thinking underlies good diversification, then the next step is to find out how many distinct groupings one can find that fulfill the criterion that the components move together for some logical reason and that the groups may move in directions opposite to each other given the same conditions. The companies that put together ETF's generally take that into account in order to design and market an ETF.

Good Sub-Asset Groups Have Long Histories

The long history of a properly constructed sub-asset group makes for quite an attractive feature to our expert advisor. With years of daily data, the numbers for performance, yield and covariance in relation to other groups allow her to construct apparently stable behavior profiles. From these profiles, she can decide what percentage of your funds to allocate to each group in order to both capture equity risk premium and to increase safety through diversification.

This same quality of asset classes may also create a false sense of security among amateur purchasers of ETF's. Normally, when a mutual fund opens its doors, it can only report its performance since inception. That should make perfect sense. An index fund, however, can report the performance of the underlying index since its composition is entirely composed of that index. The performance figures for ETF's do not reflect the same kind of performance that a history of an active fund shows.

When a particular sector of the economy outperforms the others, the creation of an ETF around that grouping makes for easier sales to those who want to enjoy the gains without the labor of picking stocks in the outperforming area. Marketing efforts for these funds become easier as the trend continues and everyone wants to jump on board. Thus, a new index ETF may report stellar performance just as the sector or group it's composed of heads for a fall.

Prudent Practice Avoids Trendy ETF's

Sometimes though, the temptation to produce a product that people will buy may lead to products which don't suit the Prudent model particularly well. A fund which holds physical silver and gold may accurately represent the precious metals as an asset class, but a fund which uses rolling futures contracts and buys or sells based on robust technical indicators doesn't represent the type of diversifier one seeks in a prudent investing plan.

Avoid ETF Equity Overlap

Overlap represents a significant danger to a good diversification plan. Most index ETF's hold equities on a cap-weighted basis. That means there will be more shares of expensive companies in the fund than shares of lower prices, less capitalized companies.

Consider the American behemoth General Electric (GE.) It's one of the largest companies in the world. How would you classify it? Large cap, domestic, durable goods provider? Do you know that a large share of its business comes from its financing arm, so part of GE behaves like a bank?

GE could be a large portion of several different ETF's. That means that a number of the parts in your portfolio you had counted on to act differently may end up acting the same way because of the elephant in the room. In order to be sure that your diversification is effective, an expert should perform a thorough drill down to check for this kind of overlap.

In both bull and bear markets, popular media advise strongly that lower fees guarantee a larger return. After all, if you avoid a 1% fee, then you have 1% more money for yourself. John Bogle, founder of Vanguard funds, advocates that individual investors pare away most all fees and “take what the market gives them.”

Prudent experts know that fees can impede return. On the other hand, the expert has a positive duty to make sure that each part of the trust operates smoothly and that often requires delegation. In order to delegate, the advisor must be sure that the service you get adds value to your overall portfolio, either in terms of safety or return. Additionally, he needs to be sure that the fees each expert delegate charges reasonable and customary fees for the services he delivers.

Most importantly, a Prudent Fiduciary may not have a set opinion about fees or commissions, but instead must investigate which of these are necessary and reasonable.

Actual Benefits, not Manner of Compensation Guide Decisions

As an example, it may not be worthwhile for a CFP advisor to spend an hour or two on life insurance planning for a 40 year old with a spouse and two children when the same work can be done at no additional cost by a competent insurance agent. Incurring a fee over and above a commission on that issue simply does not make sense. The client requires competent planning, and if there was a prejudice about fee only issues, then the cost of the service would be greater than it needed to be.

Perhaps the hottest button for investors is the question of mutual fund and advisor fees. With the availability of very inexpensive ETF’s (Exchange Traded Funds,) some would think that mutual funds are a thing of the past. If no one can choose stocks consistently in such a way as to outperform the market, then paying for these services makes no sense. And the popular press is filled with quotes about managers who can’t beat the market net of fees. In light of the fact that individuals and institutions pay billions of dollars per year to portfolio managers, a Prudent expert must examine this statement carefully. On closer examination, the common thinking about stock pickers may be a bit of journalistic sophistry.

Skilled Managers May Reduce Risk

Those who subscribe to the strong form of the Efficient Market Hypothesis must believe that no manger can gain an advantage in choosing stocks at any time. Each price at every time is perfectly correct because of the accumulated wisdom of “the market.” Those who believe the weak form of the EMH may allow that some managers have skill, but that a given investor could not tell whether a particular manger was lucky or skilled.

In fact, it may be that paying a portfolio expert to choose certain stocks over others is money well spent. A Fiduciary Expert knows and uses various means to determine if indeed the managers are worth their fees.

So while the press may lead you to believe that the only way to invest is through the use of very low cost measures, it’s worth remembering that some valuable services are worth paying for.