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.