Many ETFs introduced over the last few years have been increasingly complex securities, which are best avoided by most individual investors and advisors. While some of the new strategies reaching the market are intriguing and useful for more sophisticated investors, others are gimmicks that most investors would be best advised to ignore.

Many of these new products were able to make it the marketplace because of some well-known facts that have resonated when comparing mutual funds to ETFs.

First, ETFs are definitely more liquid than mutual funds. Second, and more importantly, is that ETFs tend to be more tax-efficient than similarly constructed mutual funds. Finally, the average expense ratio on ETFs is lower than mutual funds. These factors help explain the meteoric growth ETFs have experienced over the last 10 years.

So how can unsophisticated investors benefit and put ETFs to work in their portfolio, while avoiding some of the less-appealing product?

The answer lies at the boundary of their circle of competence. In other words, as their advisor, you need to keep it simple. Keeping it simple has benefits of its own when dealing with something as complex as investing and as important as your client's financial well being.

Instead of focusing on the nuances of complicated alternative products, such as managed futures and commodities, clients should decide whether or not they can tolerate some market risk. This can easily be accomplished with just a few products that require regular, but infrequent, rebalancing. If they want more risk and potentially more return, have them increase their stock allocation.

Or, if wealth preservation is the big concern, have them put more money into bonds and cash. By doing so, they'll get most of the return that the perfectly executed but more complex strategies can add. However, the ease of implementation will leave them with less chance for error and will reduce the headache of constantly researching new investment alternatives.

And they don't need tons of funds to do this. They can achieve a broad-based, globally focused portfolio of stocks and bonds with just four funds. Here is just one example of a hypothetical portfolio of four ETFs: 1. iShares Barclays Aggregate Bond (ticker AGG), weight, 40%; 2. Vanguard Total Stock Market ETF (ticker VTI), weight, 40%; 3. iShares MSCI EAFE Index (ticker: EFA), weight, 15%; 4. Vanguard MSCI emerging markets ETF (ticker: VWO), weight, 5% (their expense ratios range from 7 basis points to 35 basis points).

What makes these funds right for many people? For starers, they provide extremely broad market coverage at the lowest prices available to most individual investors. Their strategies, while far from exotic, are time tested and will likely never go out of style.

If your clients are looking to enter the Zen-like state of passive investing using ETFs, they need to set their expectations for performance accordingly. They need to understand they are not likely to end up in the top quintile of fund performance: That means that bragging rights are out. The trade-off is that indexing assures that you will have an above-average long-term result due to the lower all-in costs and taxes.

The key is having the discipline to let the strategy do all the work for you. Understand your limitations in predicting how the market will move over the course of an investment horizon. By doing so, you will capitalize on the advertised benefits of ETFs: tax efficiency, low costs and broad diversification. Without that discipline, you'll just become another trader subjected to some of the poor behavioral traits that humans can possess.

Among ETF detractors is John Bogle, founder of Vanguard and perhaps the most practical investor of the last century.

He correctly points out that ETFs trade with much greater frequency than mutual funds, which often leads to taxable events and poor market timing. He even noted his utter disdain when the first ETF (now the most actively traded security on the planet) launched: the ubiquitous SPDR SPY. The marketing for the fund stated that now you can trade the S&P 500 all day long, to which he commented, "What kind of lunatic would want to do such a thing?"

I agree with Bogle on this point, a strategy of intra-day trading of the S&P 500 will likely lead to poor results for the vast majority of people.

Bogle's point was that ETFs enable investors to make irrational decisions. He further conjectured that allowing those mistakes to be made is akin to promoting such behavior.

But he has also stated that investors would have likely had marginally better performance by buying and holding Vanguard's Total Market ETF than if they held the comparable fund under the mutual fund structure. Granted, that benefit would only be about two basis points, but that comparison is between the available-for-all ETF and the lowest-fee institutional class mutual fund. In my eyes, he was stating that, for investors that suppress their animal instincts to trade, the ETF had broken through the fee class structure that has hindered retail investors for years. Low costs and tax efficiency are now a reality.

For those who trade too often, however, Bogle's contention rings true.

If ETFs prompt you to irrationally trade more frequently than you would have with a portfolio of mutual funds, should you be stand down? If you want to keep your investor experience in line with efficiency promise of ETFs, keep the trading of your core portfolio to a minimum.

Look Ma, No Hands!
If this sounds like a decent proposition to you, then the hands-free product may interest your clients.

First and foremost, very few of you should adopt the hands-free approach (passive model portfolio from Morningstar) exactly as it is structured today. I recommend using the components. Be sure to establish your own asset allocation before you begin.

A good rule of thumb for total equity exposure is 100 minus a person's age. So, for example, if your client is 40, then 60% of the investable assets would be in equities. Thus, using our current allocation percentage breakdown probably is not right for your client unless he or she is relatively young. Instead, it's best to focus on the asset class allocation percentage below and apply that to portions of fixed income and equities separately.

Once you have identified how much of each fund your client wants to buy, it's time for trade execution. Equally as important as limit orders and making sure of getting good price execution for the hands-free investor is forming an optimal compromise between your client's asset allocation and the number of transactions he or she must engage in.

The act of rebalancing an asset allocation is the closest thing an investor will ever get to a free lunch in investing. It's a counter-cyclical move that by definition buys one asset at a lower price and sells one at a higher price. Granted, it may take years for the benefit to materialize, but the rewards will be very noticeable.

The challenge is, in reality, that rebalancing "free lunch" is not free. Transaction costs, including the actual commission you pay, bid-ask spreads on your purchase, and the taxes you'll incur add up fast. So financial theory may tell you to rebalance monthly, but theory doesn't account for the reality of all those costs. With a rational assessment of those costs, the frequency with which your client rebalances should fall to just once every year or so. Sure, if the market goes haywire and the allocations get all out of whack, you may need to have an intervention.

But nine years out of 10, you should be able to sit back and let idle hands do all the work.

Register or login for access to this item and much more

All Bank Investment Consultant content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access