The exchange-traded fund (ETF) market is constantly evolving. ETFs have evolved from a way to temporarily park cash in asset classes, to become a sophisticated set of tools that can be used to help people invest like professionals. There are a number of benefits to building a portfolio with ETFs, including lower fees, liquidity, almost limitless combinations of actively and passively managed funds, the ability to invest directly in the investments, and avoiding cash holdings.

Since ETFs are, for the most part, a hands-off investment, more time can be spent focusing on asset allocation and studying the years of research provided by the capital asset pricing model (CAPM). ETFs also have a very broad range of asset classes that use diversification and portfolio optimization, which are features many investors have not been exposed to in the past. Finally, ETFs offer an efficient opportunity to choose a style of management - whether strategic, dynamic or tactical - and stick to it. With all of these benefits, ETFs are taking a bite out of the mutual fund business, and allowing investors to build all-ETF portfolios.

ETFs Vs. Mutual Funds
Mutual fund companies charge fees to manage assets based on the amount invested in the fund. Traditional mutual fund fees can range from a few basis points for an index fund to over 2% for specialized international funds; if the fund manager is successful over time, the fees charged are rarely called into question. When performance goes south for a fund manager, the first items to come under scrutiny are both fees and cash on hand. Questions arise as to why a manager gets paid to lose money or manage a cash position, and active managers have been battling the index for as long as the index has been around. While ETFs are a form of a mutual fund, there are some key differences. Because ETFs trade like stocks, there is a transaction cost associated with trading them, but unlike with mutual funds it doesn't increase with the amount invested.

Asset Allocation in ETFs
If ETFs were around during the development of the CAPM, the testing and research would have been more streamlined. The inputs are based on the returns from indexes that are theoretical by nature. For example, it's nearly impossible to replicate most bond indexes, due to their sizes and the fees associated with mutual funds that attempt to replicate them. ETFs are the perfect solution to not only test theories such as CAPM, but actually invest according to the principles of CAPM and efficient market hypothesis with real-life investments. Since ETFs have low fees, are very liquid and can closely replicate indexes, investing and optimizing portfolios is much easier than using traditional mutual funds.

For years, asset allocation has led the battle between stock picking and sticking to a plan. While the results vary over time periods, the evidence is strong that active management prevails less than half the time, according to Roger G. Ibbotson and Paul D. Kaplan's 2000 study in the Financial Analysts Journal, "Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance?" With this information on hand, individual investors should spend more time on overall asset selection rather than getting caught up in which individual stocks to own.

Strategic, Dynamic, Tactical … Just Pick One
Now that the tools are available for efficient asset allocation, all that's left to do is to pick a style and implement it.

The "strategic" style has its merits for investors who like to follow a straightforward routine. It's a matter of using buckets of assets and setting a schedule to rebalance them. The key with the strategic style is to follow the rebalancing plan and avoid temptations to overreact.

"Dynamic" and "tactical," among other styles, all have their appeal too, especially to those investors who have a good track record of predicting shifts in performance trends. Investors can take their asset allocation decisions even further with ETFs by using them to target sub-sectors of each asset class.

There are many theories about why stock picking is successful only some of the time, including intense competition, high costs and the lack of (legal) information available to help investors exploit inefficiencies in stock prices. With regulations like the Sarbanes-Oxley Act of 2002, it is even more difficult for stock analysts to find undiscovered opportunities. While there is clear evidence that active management can be relatively successful, that success is usually short lived, as other analysts follow along to exploit the same opportunities.

Picking the Right ETFs
Picking ETFs is much easier than picking traditional mutual funds. Mutual fund selection is like a moving target with many moving parts. Most ETFs, on the other hand, have very defined targets and are quite transparent, except for a small minority of actively-managed ETFs. Due to an efficient competitive market, the variances between similar ETFs will be small, especially those targeted at indexes, so picking the best ETFs should be simpler. In addition, most of the research available on ETFs is predominately quantitative, as there is little incentive for interested parties to sell them as products, because commissions are minimal.

The Bottom Line
ETFs are one of the best innovations presented to investors since traditional mutual funds. They were designed with investors in mind, and since they are index funds at their core, their use compliments the many studies emphasizing long-term asset allocation over stock picking and active management. While there are transaction fees associated with trading ETFs, using a combination of discounted brokerages and minimal maintenance fees, investors can keep a larger percentage of their money. With ETFs, the average individual investor can replicate styles and strategies and have the same access to investments that large institutional investors have.