Individual investors seeking to asset allocate and build a diversified portfolio are likely to not find any better investment product to serve their purpose than ETFs. As the name implies, Exchange Traded Funds (ETFs) are investments that combine the advantages of index funds with the trading flexibility and continual pricing of individual stocks and bonds. Over the past several years, ETFs have become a very popular and inexpensive way to “trade” the market or buy specific asset classes. However, and more importantly, ETFs are an excellent way to asset allocate.

Although not without its critics, it is common wisdom among investment professionals that asset allocation is the most important investment decision. The vast majority of variation in returns can be explained by asset allocation.[1] (For more on this subject, see my article, “Asset Allocation: A Most Important Investment Decision.” posted here.)

Since Brinson et al published their landmark study, numerous academic studies have largely reached the conclusion that professional money managers add very little value by their selection of individual stocks or attempts at market timing. However the asset classes are defined, the allocation of funds among them is the most important decision an investor can make, not in picking individual investments within the classes.

Increasingly ordinary investors accept those findings. Contrary to the constant admonition from professional money managers that “it’s a stock picker’s market”; picking stocks is often a fool’s errand. ETFs allow you to easily target an asset class, with more flexibility and accuracy than either index or actively-managed mutual funds, and often cheaper as well. That is why they are soaring in popularity among small investors.

There are more than 400 ETFs listed in the U.S. and more likely to be offered. Some might call this overkill. Typically, most ETFs are passively managed and set up to track major market indexes (The Dow, The S&P, and the Nasdaq or some subset thereof). In most cases (there are exceptions), ETFs seek to achieve the same return as a particular market index. Such an ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. Index funds, such as those available through such mutual fund companies as Vanguard, were predecessors to today’s ETFs.

In many ways, ETFs incorporate the best features of all investment funds. ETFs offer investors an inexpensive way to index. Investors can purchase and sell ETFs through a broker at any time of the trading day and employ stock-trading techniques, such as limit orders, buying on margin (with borrowed money), and selling short (selling borrowed shares). Unlike index funds or mutual funds, investors must buy or sell ETF shares in the secondary market with the assistance of a stockbroker. Because your broker will charge a commission, trading costs may offset other cost advantages of ETFs. However, when designing an investment portfolio with a long-term passive investment strategy, and using a discount broker to buy the shares, the cost is nominal and far less than the costs associated with competing methods (mutual funds or buying individual stocks).

The emergence of ETFs are the latest in a long list of solutions to the problem “Main Street” (individual) investors faced in building a diversified investment portfolio of risky assets efficiently and economically. The mutual fund industry essentially grew up out of the need by individuals to achieve portfolio diversification economically. At the time when mutual funds were entering the investment scene, brokerage commissions were prohibitive for the amount of money available to individual investors to build diversfied portfolios. Since mutual fund companies could get the benefits of scale and transact at wholesale rates, they could pass the savings onto their investors. Individuals were willing to pool their assets in these funds.

With advances in electronic trading and the demise of fixed rate brokerage commissions, online discount brokers have emerged significantly reducing the cost to transact on the various national exchanges. At the same time, individual’s assets have grown while mutual fund expense ratios have remained relatively unchanged. In addition to fund expense ratios, mutual fund investing can include other costs such as distribution, marketing and sales charges. Relative to the index they are designed to track, the performance for funds that are passively managed (strive to track certain market indexes), has been at best marginal primarily due to excessive fees.

Due to the nature and construction of mutual funds, shares can only be purchased and redeemed by the fund. The price investors pay for mutual fund shares is the fund’s approximate per share net asset value (NAV). When mutual fund investors want to sell their fund shares, they have to sell them back to the fund at their approximate per share NAV. The investor only gets the end of the day closing price for their shares. Conversely, ETFs can be bought and sold in the secondary market at any time throughout the trading day.

Mutual funds are managed by investment advisors. These advisors pick and choose when and what goes into the portfolio. Though managers often strive to balance individual share gains and loses in the fund, the distribution of gains can trigger untimely tax events for investors. For tax-exempt accounts, such as IRAs and 401K plans, this has not been a problem. As IRAs and 401K plans have grown to be the primary retirement vehicle for Main Street investors, mutual funds have emerged as the principle investment product for retires. With ETFs, investors have the option to choose when to buy and sell giving investors control over timing gains and losses.

With mutual funds, investors have very little say in directing investments. As individual investors have become more knowledgeable in the ways of managing their personal assets, and as those assets have grown both inside and outside their retirement accounts, they have become more interested in managing and constructing their own portfolios. As a consequence, ETFs have emerged as an efficient and inexpensive way to manage and build an investment portfolio. In addition to building “market” tracking portfolios, investors are also interested in targeting specific investment themes. As financial commentator Jennifer Openshaw (The Millionaire Zone) points out, the real story for ETFs lies in the growing sophistication and new investor choices that result. Openshaw correctly informs that “ETFs are rolling out with more specialized and strategic designs as they sail beyond traditional index-fund roots towards the horizon of true active management. Until recently, ETFs only gave the ability to buy a broad industry or sector as defined by broad S&P or Dow Jones Sector Indexes like Technology, Consumer Cyclicals, Energy, Biotechnology, etc. You were out of luck if interested in Canadian oil sands energy exploration, but now there’s the Canadian Oil Sands ETF ( CLO: TSX). If you think water is the next oil, check out the PowerShares Water Resources Portfolio (PHO: AMEX).”[2]

Below is a list of advantages for using ETFs in place of mutual funds and stocks:[3]

• Tax efficiency

• Lower costs (ordinary brokerage commissions apply)

• Transparency

• Buying and selling flexibility

• All day tracking and trading

• Diversification

• Dividend opportunities

• Wide array of investment strategies

  • Core investment

  • Portfolio diversification

  • Hedging

  • Cash management

  • Rebalancing

  • Tax loss strategy

And where do you look to learn more about ETFs? The Yahoo! Finance ETF Center is an excellent place to start. The Yahoo! Finance ETF Center contains an extensive list of listed ETFs along with performance history. You may find it helpful to check out the ETF Education Center at Yahoo. Other sources of information can be garnered at ETF manager sites - iShares, PowerShares, Rydex Investments, and Claymore. Each of these sites contain tons of information on ETF basics and the use of ETFs as an asset allocation tool.

A word of caution. Not all ETFs are created equal. It is important to read the prospectus and understand the basket of stocks or other assets that underlie a particular ETF. As well, shorting, hedging and buying and selling options on ETFs is not advisable to the uninitiated or novice investor. Many of the newer ETFs (especially those managed by Proshares, Rydex and Claymore) use leverage and sophisticated trading strategies designed to achieve a certain trading or investment objective (such as shorting oil, currencies, or emerging markets). Some ETFs are designed to perform in the inverse direction of the underlying market they track. For instance, the Proshare Short S&P 500 make money in a declining stock market and lose money in a rising market. Thus, if you think the market is primed to decline and you want to hedge your portfolio for a decline in the market, you would buy (yes buy, not sell) the Proshare Short S&P 500. Remember, in the case of the Proshare Short S&P 500, the value rises when the market falls. You might ask, why would you want to buy a Proshare Short ETF when you could just short the index itself using SPDRs (SPYs), an ETF on the S&P 500. Well as it turns out, it is not possible to sell short in some retirement accounts such as IRAs so buying a Proshare Short ETF is a good way to hedge your stock portfolio from market risk in an IRA. For more on this topic, take a look at the following article at SeekingAlpha, “A Closer Look at the Proshare Inverse ETFs.”

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Tax efficiency
ETFs, like index funds in general, tend to offer greater tax benefits because they generate fewer capital gains due to low turnover of the securities that comprise the portfolio. Generally, an ETF only sells securities to reflect changes in its underlying index. Exchange trading of ETFs further enhances their tax efficiency. Investors who want to liquidate shares in an ETF simply sell them to other investors through exchange trading. Because of this unique structure, ETFs are not required to sell securities to meet investor cash redemptions, potentially generating capital gains tax liability for remaining investors. Keep in mind that the sale of an ETF will generate capital gains/losses for the investor liquidating shares.
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Lower costs
Expenses can have a significant impact on returns for investors. ETFs, in general, have significantly lower annual expense ratios than other investment products. ETFs are less likely to experience high management fees because they are index-based, not “actively” managed. And, since they trade on an exchange, ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. Of course, an investor selling ETF shares may realize capital gains or losses, as with common stocks. Purchases or sales of exchange traded funds are subject to brokerage commissions.
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Transparency
ETFs generally are designed to correspond to the performance of their underlying index or commodity.
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Buying and selling flexibility
Because they are exchange traded, ETFs can be:bought and sold at intraday market prices

purchased on margin

sold short

traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade
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All day tracking and trading
ETFs are priced and traded throughout the day, and are not restricted to once-a-day trading at the end of the day. And because the pricing of ETFs is continuous during trading hours, investors will always be able to obtain up-to-the-minute share prices from their broker or financial adviser.
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Diversification
Because each ETF is comprised of a basket of securities, it inherently provides diversification across an entire index. Additionally, the expanding universe of ETFs available at the American Stock Exchange offers exposure to a diverse variety of markets, including:

• broad-based equity indexes (such as total market, large-cap growth, and small-cap value)

• broad-based international and country-specific equity indexes (such as Europe, EAFE, and Japan)

• industry sector-specific equity indexes (such as healthcare, energy, and real estate)

• U.S. bond indexes (such as long-term Treasury bonds and corporate bonds)

• commodities (such as gold, silver, and oil)
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Dividend opportunities
Dividends paid by companies and interest paid on bonds held in an ETF are distributed to ETF holders, less expenses, on a pro rata basis. Of course, not all companies will pay dividends. Based on past performance, few, if any, distributions can be expected from certain ETFs. There may also be opportunities for reinvestment of distributions.
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Wide array of investment strategies
Investors can capitalize on the convenience and flexibility of ETFs to pursue a wide variety of investment strategies.

Core investment-Investors can use ETFs as a core investment for their portfolio. The purchase of shares in a single ETF can provide broad market exposure for long-term holding that is easy to establish, easy to track, inexpensive, and tax efficient.

Portfolio diversification-ETFs cover virtually every segment of the equity market and several segments of the U.S. bond market and commodities, providing an easy and convenient way to adjust the investment mix of a core portfolio.

Hedging-Exchange traded funds can be purchased on margin and sold short, which has opened up risk management strategies for individual investors that were once available only to large institutions. For example, ETFs can be sold short to hedge a core stock portfolio or interest rate fluctuations. This allows investors to keep their portfolio intact while protecting them from market losses. In a declining stock market or rising interest rate environment, profits from a short position can offset some of the losses in a portfolio. (Investors are required to make arrangements to borrow securities before selling short.) Listed options, available on some ETFs, also offer opportunities for additional hedging or to increase income. Investors should contact their broker regarding initial and maintenance margin requirements. To view a list of ETF options that are listed at the Amex, click here.

Cash management-ETFs have often been used to “equitize” cash, providing a way for investors to put cash to work in the market or maintain allocation targets while determining where to invest for the longer term.

Rebalancing-Investors can adjust ETF positions at any time throughout the trading day, without redemption fees or short-term restrictions. Again, usual brokerage commissions will apply.

Tax loss strategy-An investor can sell a security that is under performing and claim a tax loss but retain exposure to its sector by investing in an ETF. Consult a tax advisor about a tax loss strategy.
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[1]Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal, July/August 1986.
[2]ETFs: From Niche Market to Supermarket
[3]American Stock Exchange, Education, Individual Investors

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Three asset classes - stocks, bonds, and cash make up the investable universe of all assets. How investors choose to allocate their investment dollars across these classes can have a significant impact on the long-term return of an investor’s portfolio. The decision to hold stocks, bonds or cash and in what amounts is believed to account, on average, for the bulk of the variation (risk) in an investor’s return. For a given investor, determination of the optimal mix is what is commonly referred to as an investor’s investment policy or asset allocation policy. It is also known as the asset mix, investment mix, and asset allocation for short.

A capital investment or equity ownership in an entity, commodity or enterprise is represented by holding an ownership certificate, stock. Equity investors earn a return premium that compensates for the perceived level of risk relative to the two other asset classes (bonds and cash). Equity ownership is indefinite, i.e. return of income is uncertain. Bondholders are lenders and they purchase debentures (debt contracts), in the form of bonds, and lend cash for a predetermined period of time. In return for lending their money, bondholders earn a rent, or rate of interest on the principle balance lent. Investors in cash earn the equivalent of a risk-free rate of return on their money. Stock and bond investors typically earn a risk premium, the rate of return above the risk-free rate that an investor demands for assuming risk. The rate of return on a risk-free investment, short-term (overnight) lending, is usually equal to or less than the rate of inflation.

A risk asset is an investment whose real (inflation-adjusted) return and the safe return of principle is uncertain. On the scale of least risky to most risky, cash is least risky and stocks are viewed as most risky. This is because stockholders are second to creditors, lenders of money, in the return of capital. Bondholders get paid before shareholders. As a consequence, shareholders demand higher rates of return to bondholders and bondholders earn higher rates of return to cash investors (who face virtually no insolvency risk). Portfolios made up of different proportions of stocks, bonds and cash will vary in return and risk (defined as the variance in return). There is a tremendous difference between a portfolio whose mix is 80% stocks, 15% bonds, and 5% cash and one whose mix is 60% stocks, 30% bonds, and 10% cash.

Typically, investors are characterized as either passive or active. Passive investors construct their portfolios by buying and holding a collection of randomly selected securities, a diversified portfolio. Investments are purchased with the intention of obtaining long-term appreciation and limiting turnover and maintenance. Passive management is better known as indexing, the designing of a fund to mirror the performance of a published benchmark. Unlike passive management, active portfolio management attempts to add value through one of two active strategies, market timing or security selection. Market timing is an attempt by an investor to benefit from the divergence of the current value of an asset from its “correct” or “rational” level. Security selection attempts to add value by purchasing undervalued (mispriced) securities or emphasizing a group of securities that make up an investment theme, i.e. small capitalization over large capitalization stocks. The objective with active management is to produce better returns than those of passively managed index funds. It has been demonstrated that active management detracts more often than not from overall portfolio performance; that asset allocation plays a more important role in overall portfolio performance.

Over the years, there has been considerable debate as to the importance of an investor’s asset allocation policy. In 1986, Brinson, Hood, and Beebower (BHB)[1], three knowledgeable investment management practitioners, studied the performance of ninety-one large U.S. pension plans over the 1974-1983 period and concluded that “investment policy (asset allocation) dominates investment strategy (market timing and security selection), explaining an average of 93.6% of the variation in total pension plan returns”. Others (most notably Jahnke[2] and more recently Kritzman[3]) have argued that BHB’s original conclusions and methodology are flawed. They contend that too much importance is given to asset allocation; that market timing and security selection have been marginalized.

Without getting into the specifics, Modern Portfolio Theory describes markets as efficient (all publicly available information on an asset is incorporated in the asset’s price nearly instantaneously). If one believes markets are informationally efficient, then it would be difficult to add value from active management. The certainty of market efficiency has been brought into question by some market practitioners, and thus as well, the relevancy of asset allocation. With little uncertainty, suffice it to say that we can probably ascribe efficiency to markets over the intermediate to long-run, which after all is what we should be concerned with as investors. Conventional wisdom accepts that for the “average” investor (especially the unsophisticated investor) it is very difficult to beat the market (earn a rate of return greater than the risk premium associated with an amount of risk). As well, it has been proven, again Modern Portfolio Theory, that in the case of a specific asset class (for instance, stocks), an investor does well to invest in a diversified portfolio.

In my experience, unsophisticated investors (those who do not make a career out of stock picking) are far off better focusing on the asset allocation decision than worrying about which stocks or bonds to hold (security selection) or when to buy them (investment timing). It is clear from financial theory and practical experience that investors’ asset allocation choices should be linked with their specific circumstances or long-term financial goals. Investors determine their asset allocation policy based on their risk tolerance, their financial goals, their time horizon, their non-financial wealth (such as employment income), and the risk premiums of the asset classes.

That is not to say that certain individuals using superior research or first-hand experience cannot take advantage of unique information from time to time through active portfolio management (trading). However, it is likely that the knowledge will become known by the rest of the market, or as well, be in the possession of others, and therefore in the long-run not have any intrinsic value. Only if investors have the ability to predict expected returns in financial markets can tactical (active management) asset allocation enhance portfolio performance. Keep in mind that the degree of skill required to justify an active management strategy is very high. Investing on the basis of event driven information (such as earnings releases or change in corporate control), which may materially impact the value of an enterprise, is likely to be viewed as insider information and construed as illegal.

A better way to consider this issue is to determine whether or not having better information about the asset changes its risk profile and thus the willingness of an investor to assume risk. If so, an investor should be willing to increase such holdings in his/her portfolio. As an investor becomes more knowledgeable about the ownership of equities and more comfortable with their risk, he would then consider increasing his allocation to equities, presuming the allocation meets his risk tolerance.

A passive investment strategy (no trading) with rebalancing (resetting the asset mix to meet your specific circumstances related to return objectives and risk tolerances) is likely to incur lower costs to manage than active portfolio management (buying and selling assets based upon market timing and security selection). The BHB study found that, on average, tactical asset allocation (market timing) and security selection work to detract 1.1 percentage points from the return that would have been achieved with strategic asset allocation (a passive investment strategy) alone. Depending upon one’s time, commitment, and experience, he/she might be better off creating a diversified portfolio of stocks or bonds by choosing to use exchange traded funds (ETFs) encompassing a basket of assets that replicate a “market” portfolio.

In the BHB study, it was found that a portfolio’s asset allocation policy dominates portfolio performance, and over a period of time typically explains over 90 percent of the variation in the portfolio’s returns. However, that is not to say that within a given portfolio’s return, active management did not play a role in imparting a return that varied significantly from a portfolio benchmark. The average ten-year annual return of the 91 actual portfolios was 9.01% and ranged from 5.85 percent to 13.4 percent. Portfolios yielding returns in excess of the average in all likelihood may have been attributed to superior skill or knowledge. As well, they were likely to have been far and few between; the exception. In the long-run, due to competitive forces, the benefit of skill and predictability will average out - losing as often as winning and reverting returns to the mean. Financial theory and empirical evidence show that exposure to systematic risk (market risk) is compensated over time. Active management risk is not compensated on average (Sharpe, 1991)[4]; however, it is compensated if skill overcomes the higher cost hurdle of active management. Active management creates opportunity to outperform. However, the most important consideration is how much extra return active management can add without exposing the portfolio to unwarranted risk. Overcoming the higher cost hurdle of active management is a challenge.

As L. Randolph Hood, the “H” in BHB, stated in a letter to the Financial Analysts Journal 20 years hence first publishing their findings in 1986, “Our message today remains the same as before: Carefully consider what goal you are trying to achieve, how important it is to achieve it, and how much risk you are willing to tolerate in pursuing it. Then, create a policy portfolio (a portfolio allocated to the three major asset classes - stocks, bonds, and cash) that reflects that goal and your risk tolerance for probable outcomes - because executing that policy will have a dominant effect on your success.”[5] Investment policy (the asset allocation decision) should be addressed carefully and systematically.

[1] Brinson, Gary, Randolph Hood, and Gilbert Beebower. “Determinants of Portfolio Performance.” Financial Analysts Journal, July-August 1986, pp. 39-44.

[2] Jahnke, William. “The Asset Allocation Hoax.” Journal of Financial Planning, February 1997, pp. 109-113.

[3] Kritzman, Mark. “Determinants of Portfolio Performance-20 Years Later”: A Comment. Financial Analysts Journal. January/February 2006, Vol. 62, No. 1: 10-11.

[4] Sharpe, William F., 1991. “The Arithmetic of Active Management.” Financial Analysts Journal 47 (1): 7-9.

[5] Hood, L. Randolph, CFA. “Determinants of Portfolio Performance - 20 Years Later.” Author’s Response. Financial Analysts Journal. September/October 2005, Vol 62.

The opinions and views expressed in this article do not necessarily reflect the views of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.