More ETF Advantages - Diversification & Costs By J.D. Steinhilber December 5, 2002

In a previous article we looked at the tax benefits of exchange-traded funds, as well as fund swap strategies to harvest portfolio losses. This time we continue on with more ETF advantages.

Diversification

Most advisors would agree that diversification is the single most important investment priority. Effective diversification is most readily achieved by combining poorly correlated asset classes in a portfolio. One of the most basic examples of two poorly correlated asset classes is stocks and bonds. Over time, the returns of these two asset classes have a very low level of correlation. Over shorter time periods, the degree of correlation between stocks and bonds can vary widely. From January 1999 to October 2002, for example, stocks and bonds had a negative, or inverse, correlation. REITs and international stocks are examples of other asset classes that tend to be poorly correlated with U.S. stocks.

Because exchange-traded funds replicate the performance of entire asset classes, which themselves are diversified among numerous securities, it is possible to construct well-diversified portfolios with only 5-10 ETFs. Accordingly, ETFs provide a highly efficient means of diversification.

Mutual funds also facilitate diversification, but actively managed mutual funds are susceptible to "style drift" and their portfolio holdings at any particular time are unknown. This presents a challenge to diversification efforts. In contrast, ETFs offer asset class purity, meaning their holdings are totally transparent, disclosed daily and not subject to style drift. Actively managed mutual funds are also more expensive and less tax-efficient than ETFs.

Asset Class Investing

Asset allocation - how a portfolio is divided among various asset classes - is the primary determinant of investment performance. Accordingly, one of the most valuable services a financial advisor can provide is to complete a personalized asset allocation model based on a detailed client questionnaire and needs assessment. Asset allocation models are structured to produce over time an expected rate of return and an expected variability of returns, based on the assumption that long-range future returns will approximate long-range historical returns.

Often depending on the complexity of the software or process used for the client profiling/needs assessment, asset allocation models can range from a simple stocks/bonds/cash allocation to a highly detailed suggested portfolio encompassing a range of asset classes. In any case, ETFs are elegantly simple tools with which to implement asset allocation models because they greatly facilitate the security selection process. An advisor simply matches the asset class in an allocation model with the ETF that replicates that asset class, potentially eliminating the need for individual stock, bond, mutual fund or money manager research and selection. Alternatively, ETFs can be used for certain asset classes in the portfolio while other asset classes are addressed with different solutions.

Cost Advantages of ETFs

Exchange-traded funds have some of the lowest expense ratios of any registered investment product. As shown below, ETFs have a cost advantage, on average, in excess of 100 basis points relative to actively managed mutual funds.

A 100 basis point (1.00%) cost advantage can have a significant impact on a portfolio's performance over time. For example, assume that investor A and investor B each invest $10,000 and earn the same gross annualized return over a 20 year time frame. After expenses, assume that investor A earns a net return of 10% and investor B earns a net return of 9%. After 20 years, investor A would have $67,275, while investor B would have $56,044, representing a difference of $11,231.

It is important to point out that investors have to pay commissions when they buy or sell ETFs. As a result, the cost advantages of ETFs relative to mutual funds diminish the more actively an ETF portfolio is traded.

Investors tend to be more conscious of investment costs when portfolio returns are low or negative. Given that costs are among the few controllable variables in a portfolio's returns, investors and advisors should always be evaluating portfolio costs relative to the benefits received. Exchange-traded funds may provide an opportunity to enhance net returns by reducing investment expenses.

J.D. Steinhilber is the founder of AgileInvesting.com, an investment advisory web site that recommends ETF-based portfolios.