Diversify with Low Cost Index Mutual Funds and ETFs Only

During the last twenty-five years of the 20th century, mutual fund and exchange traded fund portfolio assembly costs declined dramatically.

Brokerage commissions were deregulated in 1975, and transaction costs have fallen very dramatically since then. Furthermore, well-diversified, low-cost index mutual funds have now become commonplace, while none existed in 1968. The mutual fund industry was still in its relative infancy. For example, there were 361 mutual funds of all kinds in 1970 with only $48 billion in assets. In contrast, at the end of 2006, there were 8,120 U.S. mutual funds of all kinds with $10.4 trillion in assets.¹

Now, very low cost index mutual fund and ETF investing is a much more efficient and effective way to achieve full market diversification.

Because investment costs have declined dramatically, higher levels of diversification can be achieved far more cost-effectively through mutual funds and ETFs today. Of course, you need to be very careful to keep the total fund expenses that you pay very low. While a minority of available mutual funds and ETFs have pursued a low cost strategy, one of the primary reasons why the number of funds has grown so phenomenally is that they are very profitable. Unfortunately, this profit to the ETF and mutual fund industry comes at the expense of individual investors, who are ostensibly “shareholders” in these excessively costly investment funds.

For many mutual funds large scale has meant large profits, because savings from these economies of scale have not been passed on to the shareholders of the funds.

This is a very stark example of an industry with what is know as an “agency” problem. When there is an agency problem, the agents of the shareholders do not act in the best interests of the shareholders. In theory, the interests of fund shareholders are supposed to be paramount in mutual funds. In practice, the boards of many mutual funds are not truly independent. Instead, these fund board serve primarily the for-profit interests of the large fund family companies that either employ the investment fund’s trustees or that pay substantial fees for supposedly “independent” outside trustees to sit on the boards of these individual investment funds.

Unfortunately, there are two boards and two sets of shareholders whose interests are in conflict - the board of trustees of each individual mutual fund and the board of directors for the overall fund family company. When the fund family is public and has a strong profit objective, then the interests of their share holders are in conflict with the interests of the shareholders of the individual mutual funds that they promote. In reality, for many mutual funds it seems that the profit interests of the shareholders of the overall fund company dominate and supplant the interests of the shareholders of the individual investment funds.

This is a clear breakdown in corporate governance. Unfortunately, these agency problems are systemic across most of the industry. The only real solution that individual investors have is to patronize only fund companies with very low fees that truly respect their obligations toward individual fund shareholders.

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These DIVERSIFICATION articles may also be useful to you:

• What is investment portfolio diversification?
• Investment securities markets do not pay you for the risks of holding individual common stocks and bonds
• Why is diversification valuable to individual investors?
• Is the average individual investor’s portfolio well diversified?
• What is the cost to individual investors of sub-optimal portfolio diversification?
• How do changes in common stock price volatility affect diversification?
• How does the size of the common stock risk premium affect diversification?
• How many mutual funds are needed for a well-diversified portfolio? – evidence
• How many mutual funds are needed for a well-diversified portfolio? – a commentary

1) [ICI 2007] Investment Company Institute. “2007 Mutual Fund Fact Book.” Table 1, p. 93, http://www.icifactbook.org/ Accessed 10-25-07

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