Asset classes are represented in a portfolio using low-cost and broadly diversified investments. Academic literature on Modern Portfolio Theory (MPT) is based on financial market returns. As such, a portfolio based on MPT works exceptionally well with index mutual funds and exchange-traded funds (ETFs). These funds are well-suited because they are designed to replicate financial market returns less a small fund expense. Index funds have low turnover of securities that make them more tax-efficient than other mutual fund types.
Both index mutual funds and ETFs follow market indexes. The primary difference is how they are traded. Index mutual funds are bought and sold once per day at the end of the day at Net Asset Value (NAV). Trading of index mutual funds is direct with the mutual fund company that manages the fund. In contrast, ETFs are bought and sold during the day on an exchange. ETFs trade close to their NAV, although there can be a very small discrepancy in the price of shares and the underlying securities that make up the fund. Those discrepancies do not last long because professional traders will arbitrage the difference. We monitor fund values closely to ensure our clients receive fair pricing. For in-depth information on ETFs, read The ETF Book by Richard Ferri.
There are a number of index mutual funds and ETFs available in all asset class categories. Portfolio Solutions® analyzes and selects the most appropriate funds for our clients’ portfolios. In our analysis we consider and evaluate underlying index structure, portfolio turnover, management fees, fund liquidity and several other factors.
Analysis of Funds
We are not biased toward one mutual fund company or another, or have a strong preference to open-end funds or ETFs. Typically, a client portfolio will hold funds from several different providers of both open-end mutual funds and ETFs. The fund providers commonly used include The Vanguard Group, Dimensional Fund Advisors (DFA), and Blackrock Investment Management (iShares®).
Portfolio turnover is very low in client portfolios. Most investments are expected to be held for many years. Although new funds are introduced into the market weekly, almost all of these products are quickly dismissed by our investment committee because they either don’t add value to a portfolio, are too expensive, or do not represent an asset class. Occasionally, a new fund is introduced that is worthy of a closer look, and it is our responsibility to analyze these funds in-depth. We are always interested in saving our clients money if a lower-cost fund option is introduced or a new fund improves the diversification of the portfolio.