Exchange traded funds are diversified, allow diversity and get around the asymmetry of information in stock picking

In medieval Europe, wealth was almost exclusively land. The land of course was owned by either the church or aristocrats. Since the aristocrats of the time were usually off fighting wars and the churchmen were burdened with their religious duties their estates were managed by stewards.

Today many investors find themselves in a similar situation. They have to hire asset managers who in theory have the education, ability, and skill to successfully grow assets as the stewards once grew crops. To respond to this demand the financial industry has developed a variety of asset managers and asset classes that hopefully fill every need.

Among the cheapest and oldest forms of asset management are mutual funds. The mutual fund has been around in the United States since 1924. They really began to hit their stride by 1960 when the number of mutual funds increased to over 270 funds. The concept behind the mutual fund is solid. It is supposed to provide professional money management and diversification.

Financial markets and investing are like any other business in some ways. Good ideas at first are incredibly successful in making money and then attract competition. According to the investment Company Institute there were 65,971 mutual funds worldwide at the end of the first quarter of 2010. These funds come in all shapes and sizes. Generally, though, they come in four types. There are equity funds which make up about 39% of the total. There are balanced/mixed funds which include both equity and fixed income and they make up 23% of the total. Straight bond funds or 19% and the remaining 5% were money market funds.

These funds are now totally global. There are not only funds in the United States dedicated to investing in emerging markets, there are funds in emerging markets dedicated to investing in more developed countries.

Of course like all other businesses, mutual funds have fees. For most mutual funds there is an advisor who controls what the fund owns, buys and sells. This advisor of course charges a management fee. In addition to management fees there are also non-management fees including fees for the custodian, legal and audit etc.

 There are also crucial fees for marketing and often fees charged by brokers to purchase the fund. Finally some funds have penalty fees, for example for example, Fidelity Diversified International Fund (FDIVX) charges a 1% fee on money removed from the fund in less than 30 days.

But it's not just the fees. It's the layers of fees. The average equity mutual fund charges around 1.3%-1.5%, which doesn't sound like much unless your return is less than that. Recently many asset managers have stopped picking the stocks themselves and started picking funds managed by others, often from the same company, thereby doubling the compensation. Then there are the fund of funds.
 
So there is an ever growing chain of rapacious asset managers inserted between the investor and the investment.

In addition to the fees and can commissions mutual funds have other issues. There is limited trading in the funds. Often you can only buy or sell the funds at the end of the day. Certain funds require minimum investments. Closed-end funds sometimes sell for a premium or discount to the net asset value of their holdings.

However the main problem with actively managed mutual funds is that 80% of them do not do any better than stock indexes.

Fortunately there is a ready solution to the problems besetting mutual funds. These of course are exchange traded funds (ETFs). First started in 1993, these funds provide necessary diversification. Since they are tied to an index they always match the performance of a specific market. They also trade like stocks. You can buy and sell them all day long. You can also sell them short, put in long-standing limit orders to buy or sell them at a specific price and there are even options.

Presently there are over 900 different ETFs. They come in all shapes and sizes. The standard ones match various indices of markets around the world. They also track more exotic asset classes like commodities, currencies and real estate. There are "story" ETFs that track frontier markets, companies located in BRIC countries or the green economy. There are also strategy ETFs that are supposed to invest in "pure growth", "pure value" and even one that follows a strategy called "Dogs of the Dow".

The demand for ETFs has been happily increasing as have the variety. Still there is one disturbing trend. The discount brokerage firm Charles Schwab just bought Windward Investment Management, an investment advisory firm. Windward has diversified investment portfolios comprised primarily of ETF securities.

Windward's clients include investment advisors, non-profit organisations, endowments, retirement plans, and individuals. So asset managers instead of being replaced by ETFs have found ways to reinsert themselves into the process.  

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected]).