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Mutual Fund Asset Allocators: ETFs and Index Funds

There are two distinct schools of thought when it comes to investing in mutual funds. One group, which I will call, “Asset Allocators”, utilizes what is commonly referred to as a top-down mutual fund investment approach. The top-down approach emphasizes the big picture by first examining the economy and condition of the broad financial markets and then evaluating individual mutual funds based on standard financial measures of comparison.

At the extreme, asset allocators may not even invest in mutual funds, believing that exchange traded funds (ETFs) are reasonable substitutes for actively managed mutual funds. Investors use ETFs for a variety of reasons but the most important and logical basis for using these financial instruments is their normally low costs, tax-efficiency, style purity as well as their specialized focus. There are many ETFs that emphasize individual parts of the market such as financials, technology and healthcare. The asset allocator who believes that technology will perform well over the next year and does not want to pay an active mutual fund manager to get this exposure would buy a technology ETF.

Asset allocators may also use index funds as a substitute for actively managed mutual funds. Index funds normally offer investors low costs, style purity and tax efficiency. Index funds strive to replicate the performance and characteristics of common benchmarks such as the S&P 500 Index and the Russell 2000 Index. Not all index funds are clones of their respective benchmarks. Some mutual fund companies design index funds to replicate the performance and characteristics of a benchmark without actually holding all of the securities in that benchmark.

The pure asset allocators prefer ETFs and index funds over actively mutual funds on the theory that mutual fund managers cannot outperform benchmarks on a consistent basis. To an asset allocator, it makes no sense to pay a mutual fund manager to under perform its benchmark. There are many financial planners and other investment professionals that utilize this approach. The use of ETFs and index funds is actually a reasonable approach if one of your goals is to create a low cost structure for your clients. On the other hand, it is not very client friendly for investment professionals to use these low cost financial instruments while still charging high fees.

Mutual Fundamentalists and Actively Managed Mutual Funds

The second group, which I will call, “Mutual Fundamentalists”, care very little about the broad market and invest almost entirely based on the fundamentals of each particular mutual fund. These somewhat rigid investors might not entirely ignore the economy and market conditions, but these issues do not drive their investment processes. Mutual fundamentalists focus on factors such as the historical performance and risk attributes of different asset classes, expenses, volatility, and especially portfolio manager and analyst backgrounds. For many mutual fundamentalists, quality of management is the most important factor when evaluating a mutual fund.

Mutual fundamentalists fully acknowledge that some passive investment strategies make sense for specific investment categories, but vigorously disagree with a blanket statement asserting that active portfolio management has no value because portfolio managers cannot outperform benchmarks. Mutual fundamentalists believe that there will always be a large group of portfolio managers who have the ability to outperform benchmarks, but that investors need to do their homework in order to find them.

Combining Asset Allocation and Mutual Fundamentalism

A better approach to mutual fund investing might be to combine the best attributes of asset allocation and mutual fundamentalism. With this approach, you could get the best of both worlds. You would have the opportunity to take advantage of changing market conditions and also have the option to select the best low cost mutual fund managers within your favored asset classes.

Whichever approach you choose, do not let mutual fund expenses weigh your returns down. Most asset allocators and mutual fundamentalists agree that high cost investments should be avoided whenever possible.

Michael A. Weiss, CFA is the editor of The Mutual Fund Investor, a quarterly publication that provides recommendations for some of the best no load mutual funds in various investment categories. To learn more about The Mutual Fund Investor, please visit http://www.mutualfundinvestor.net/.

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