Rebalance

Presenting an annual investment outlook is a hazardous task. At the start of 2011, investors were warned to eschew the bond market. Pundits described the low yields of U.S. Treasuries as a “bond market bubble.” In fact, if you had bought 30-year U.S. Treasury bonds at the start of the year when they yielded 4.42% and held them through 2011, when the yield had fallen to 2.89%, you would have earned a 34% return.

Meanwhile, U.S. stocks stayed flat, Europe and Japan declined by double digits, and emerging markets suffered even greater losses. Last year again demonstrated that it is virtually impossible to make accurate short-term predictions of asset returns.

But it is possible to make reasonable long-term forecasts. Let’s start with the bond market. If an investor buys a 10-year U.S. Treasury bond and holds it to maturity, he will make exactly 2%, the current yield to maturity. Even if the inflation rate is only 2%, the informal target of the Federal Reserve, investors will have earned a zero rate of return after inflation.

With a higher inflation rate, U.S. Treasuries will be a sure loser. Other high-quality U.S. bonds will fare little better. The yield on a total U.S. bond market exchange-traded fund (ticker BND) is only 3%. Bonds, where long-run returns are easy to forecast, are unattractive in the U.S. and Japan, as well as in Europe, where defaults and debt restructurings are likely.

Long-run equity return forecasts are more difficult, but they can be estimated under certain assumptions. If valuation metrics (such as price-earnings ratios) are constant, long-run equity returns can be estimated by adding the anticipated 2012 dividend yield for the stock market to the long-run growth rate of earnings and dividends. The dividend yield of the U.S. market is about 2%. Over the long run, earnings and dividends have grown at 5% per year.

Thus, with no change in valuation, U.S. stocks should produce returns of about 7%, five points higher than the yield on safe bonds. Moreover, price-earnings multiples in the low double digits, based on my estimate of the earning power of U.S. corporations, are unusually attractive today.

Stocks were losers to bonds in 2011. But don’t invest with a rear-view mirror. U.S. stocks, available in a broad-based index fund or ETF, are more attractive than bonds today. The same is true for multinational corporations throughout the world.

Investors in retirement, who desire a steady stream of income, can purchase a portfolio through mutual funds or ETFs tilted toward stocks paying growing dividends, with yields of 3% to 4%. And some areas of the bond market are attractive for investors who want some fixed-income investments. Tax-exempt funds that trade on exchanges (so called closed-end investment companies) that take on moderate amounts of short-term debt to increase the size of their portfolios have yields of 6% to 7%, and emerging-market bond funds have generous yields.

Emerging markets offer the best prospects for both equity and bond returns over the next 10 years. A number of fundamental factors favor the emerging economies. While Europe and the U.S. struggle with debt-to-GDP ratios of 100% or more—and Japan’s ratio is 250%—the fiscal balances of the emerging economies are generally favorable, and debt ratios are low. Low debt levels encourage economic growth.

Demography also favors the emerging economies. Dependency ratios (nonworking age to working age population) are far more favorable in emerging markets. Soon Japan will have as many non-workers as workers, and Europe and the U.S. are not far behind. Emerging markets, such as India and Brazil, will continue to have two to three workers for every nonworker. Even China, with its one-child policy, will have favorable demographics and a large potential labor force until at least 2025. Countries with younger populations tend to grow faster.

Natural-resource-rich countries will also benefit over the decade ahead. The world has a finite amount of natural resources and the relative prices of increasingly scarce resources will rise. Countries such as Brazil, with abundant oil and minerals, as well as water and arable land, will benefit from the world’s increasing demand.

Emerging stock markets were among the worst performers in 2011 despite their favorable economic performance and future outlook. Hence their stock valuations are unusually attractive relative to developed markets. Historically, emerging-market equities had price-earnings multiples 20% above the multiples for the S&P 500. Today, those multiples are 20% lower. And emerging-market bonds have significantly higher yields than those in developed markets.

Much worry has been expressed about real-estate prices and construction activity in China. “It’s Dubai times 1,000,” says one hedge-fund manager who predicts an economic collapse. Obviously, an end to China’s growth would be a significant blow to the world economy.

But parallels to the U.S. real-estate bust and the resulting damage to the economies and financial institutions of the Western world seem unwarranted. The absorption of vacant space remains extremely high in China, where hundreds of millions more people are expected to move from farms to cities. And unlike the U.S., where people bought new homes with little or nothing down, Chinese buyers make minimum down payments of 40% on a new home (and 60% on a second home).

In the U.S., savings rates fell to zero, and consumer-debt levels tripled relative to income. In China, savings rates as a percentage of income are one-third.

Most important, the government has the wherewithal and the flexibility to stimulate the economy and recapitalize banks if necessary. China has a debt-to-GDP ratio of only 17%. China’s growth will slow down from the breakneck pace of the last several years. But it will continue to grow rapidly, and a meltdown of the Chinese economy is highly unlikely.

The U.S. housing bust has made the single-family home an extremely attractive investment. House prices have fallen sharply, and 30-year mortgages are available for people with good credit at rates below 4%. Housing affordability has never been better.

Whatever the specific mix of assets in your portfolio at the start of 2012, you would do well to follow one crucial piece of advice. Control the thing you can control—minimize investment costs. That is especially important in a low-return environment. Make low-cost index mutual funds or ETFs the core of your portfolio and ensure that any actively-managed investment funds you purchase are low-expense as well.

Mr. Malkiel is the author of “A Random Walk Down Wall Street” (10th ed., paper, W.W. Norton, 2012).

Charley Ellis explains investing to Consuelo Mack of WealthTrack

New unemployment claims remain moderate. Consumer spending and business fixed investment have advanced. Stock prices are up. And the Federal Reserve announced last week that the majority of the largest United States banks continue to have adequate capital even in an extremely adverse hypothetical economic scenario.

In short, the chances of a self-sustaining recovery have improved—a “virtuous cycle” where increased employment leads to better consumer sentiment, stronger sales, and continued increases in employment.

But let’s not uncork the champagne quite yet. The strong employment gains may well have been aided by our unusually warm winter. Rising gasoline prices will put increased pressure on consumers. And a number of strong economic headwinds still exist.

The economies of the euro zone are getting worse, not better. The housing sector has yet to make a convincing turn for the better, and the economic data, as a whole, suggest the economy is growing at a rate nearer to 2% rather than its previous trend rate of 3%-4%. The realistic conclusion for investors should be “Yes, things are better, but we still have a long way to go.”

Given the present economic outlook, what is the best strategy for investors? Let’s look at three asset classes in reverse order. I will rank them from worst to best.

Bonds are the worst asset class for investors. Usually thought of as the safest of investments, they are anything but safe today. At a yield of 2.25%, the 10-year U.S. Treasury note is a sure loser.

Even if the overall inflation rate is only 2.25% over the next decade, an investor who holds a 10-year Treasury until maturity will realize a zero real (after-inflation) return. If the investor sells prior to maturity, it will likely be for less than the face value of the note if the inflation rate rises.

Even if the inflation rate remains moderate, interest rates are likely to rise to more normal levels as the economy continues to recover. Investors with long memories should recall that over the entire period from the 1940s until 1980, bonds were a horrible place to be. Given the likely trends, U.S. Treasuries and high quality bonds are likely to be extremely poor investments and are very risky.

Equities on the other hand are still attractively priced, despite their substantial rise from the October 2011 lows. A good way to estimate the likely long-run rate of return from common stocks is to add today’s dividend yield (around 2%) to the long-run growth of nominal corporate earnings (around 5%).

This calculation would suggest that long-run equity returns will be about 7%—five percentage points more than the safest bonds. This five-percentage point equity risk premium is close to the historical average.

A variety of valuation metrics (such as current multiples of earnings and book values) suggest that equities are still reasonably priced today. Only the so-called Shiller price/earnings ratio (based on the past 10 years of earnings) would suggest that stocks are too high. But the average earnings over the past 10 years are likely to be well below the current normalized earning power of U.S. corporations.

Emerging market equities are particularly attractive. The price-earnings multiples for emerging markets have traditionally been about 20% higher than for U.S. stocks. Today they are 20% lower. Over the long run, emerging markets have better demography (younger populations) and better fiscal balances than the developed markets. And they are likely to continue to grow at a far more rapid rate than the developed world.

Real estate is a particularly attractive asset class. Investors who are currently renting the place in which they live should strongly consider buying.

Real-estate prices have fallen sharply, if not to their absolute lows, then certainly very near to them. Long-term mortgages are below 4% for those who can qualify. Housing affordability (a measure based on house prices and mortgage rates) has never been more attractive. Moreover, under present tax laws there are advantages to owning since mortgage interest is deductible and rent is not.

Too many people invest with a rearview mirror. Housing has been a dreadful investment since the housing bubble burst in 2007. I believe it will be one of the best investments over the next decade.

Still, we are likely to be in a low-return environment for some time to come. While equities appear to be favorably priced relative to Treasury bonds, returns are unlikely to be at the double-digit level enjoyed from 1982 through 1999. Indeed, the California Public Employees’ Retirement System (Calpers), the nation’s largest pension fund, has just recommended that its target annual return be reduced to 7.5% from 7.75%.

In today’s environment, the minimization of investment fees is more important than ever. A 1% investment management fee may appear to be very low when measured against assets. But when measured against a 7% equity return, that fee represents more than 14% of the return. Against a 2% dividend yield, the fee absorbs one half of the dividend income.

And measured against the mediocre return of the typical actively-managed equity fund compared to lower-cost, broad-based index funds and ETFs, management fees can be very high indeed. (During 2011, over 80% of actively-managed equity funds were outperformed by the broad-based S&P 1500 Stock Index.) Despite the considerable economies of scale that characterize the investment management business, the annual management fees charged to mutual-fund investors have not declined over time. Investors can’t control returns offered by the U.S. and world financial markets. But the one thing they can control is fees paid to investment managers.

The only way to ensure that you can enjoy top quartile investment returns is to choose investment funds that have bottom quartile expense ratios. And, of course, the quintessential low-expense instruments are broad-based, indexed mutual funds and ETFs.

Mr. Malkiel is the author of “A Random Walk Down Wall Street” (10th ed., paper, W.W. Norton, 2012).

Special Report: International Banking

One such firm is Vestra Wealth, formed by a group of former UBS wealth managers. “There is an inherent conflict between trying to be an adviser and trying to sell a product,” says David Scott, one of the firm’s founders.

The biggest threat to incumbents, however, comes from outside the traditional banking sector, where hungry innovators are trying to cut the cost of investment advice and wealth management drastically. The most fertile ground for many of these new firms is in California, where a generation of technology entrepreneurs that made its money online is preparing to invest it online too. The region is already awash with traditional wealth managers. UBS, Goldman Sachs, JPMorgan and others are expanding in San Francisco and around Silicon Valley. They have recently been joined by online rivals such as Wealthfront, MarketRiders and Personal Capital, all of which use technology to help clients build customized asset portfolios at a small fraction of what traditional wealth managers would charge.

Wealthfront, which is aiming its offering squarely at Silicon Valley’s new rich, will manage money for a fee of 0.25% a year, using sophisticated algorithms that measure risk tolerance and build a diversified portfolio. Another new entrant is Personal Capital, started by Bill Harris, a former chief executive of PayPal and Intuit. It tries to straddle the world between cheap online wealth management and the old world of private banking. Customers can sign up online but the firm provides expert portfolio and tax-management advice and assigns wealth managers to individual customers. In Britain a firm called DCisions has crunched the data on millions of portfolios to obtain risk-adjusted returns as benchmarks for new investors. The data show up clearly how wealth managers’ fees have affected the value of the portfolios and what difference the managers’ advice has made.

Tom Blaisdell, a partner at DCM, a venture fund, manages his savings through MarketRiders. For a flat fee of $14.95 a month the firm assesses his tolerance for investment risk and helps him construct a portfolio of investments using exchange-traded funds that he can buy through any discount broker. The firm monitors his asset allocation as markets move and sends him quarterly instructions on what to buy or sell to rebalance his portfolio. “I’ve got a personal rant on this but 90% of what people call ‘investing’ in this country is what I call ‘gambling’,” says Mr Blaisdell. “It is a big area for innovation.”

Betterment has a simple interface that allows its customers to divide their investments between a basket of stocks and one of bonds. For a fee of 0.15% the company will keep rebalancing the portfolio between the two. Among its investors is Sean Parker, Facebook’s founding president.

Many private bankers are openly scornful of such do-it-yourself wealth management. They point to the rise of online stockbrokers a decade ago that led to predictions of the death of wealth management. Yet their business is bigger than ever because most customers are not confident enough to trade.

Even so, the newcomers’ influence is already changing the way the rest of the market works. Fees across the industry are falling and becoming more transparent. That will force banks to offer their own online wealth-management services and to invest in online systems that will provide sensible advice at low cost. Those that are best placed to succeed are likely to be large international banks with extensive retail branch networks.

* Rebalance shares the same investment platform as MarketRiders.

ETFs Have Taken Off, But They Can Be Treacherous

Exchange traded funds, low-cost packages of securities that trade like stocks, have grown from virtually nothing to more than $1 trillion worldwide in 10 years.

Institutional investors, such as those that run your mutual fund or your pension fund, use ETFs to invest new money quickly or to hedge existing positions. Financial advisers use ETFs to create low-cost, custom portfolios for clients. Individual investors use them for long-term holdings — and short-term gambling.

Although ETFs are widely hailed as solid investment tools, the maturing industry is taking its share of knocks, too. Giving investors the ability to trade funds every minute in the trading day might tempt some people to do so — and that rarely works out well. And many new ETFs are so specialized as to be almost useless for investment purposes.

“We’re now into the bastardization of ETFs by Wall Street,” says Mitch Tuchman, CEO of MarketRiders.com, a website that recommends broad-based ETFs for average investors.

ETF assets have grown far faster than garden-variety mutual funds.

The largest ETF, SPDR Trust, has $66.7 billion in assets, making the climb to the nation’s largest stock mutual fund in 17 years, counting by single share classes. The popular ETF PowerShares QQQ has $18.6 billion in assets, even though the fund has lost an average 6.4% a year the past decade.

“It’s just a matter of time before ETF assets top $2 trillion,” says Loren Fox, senior analyst for Strategic Insight, which tracks the industry. Total stock fund assets are now about $5 trillion.

Individual investors account for about half the assets in ETFs, and it’s not hard to see why. They offer a low-cost way to invest in stocks, bonds, commodities and real estate, and they let you move in and out at any time during the trading day. And they allow you to buy slices of the market, rather than choosing a few individual stocks that could blow up.

“I can be long on technology without being wrong on Yahoo,” says Jack Reutemann Jr., founder and president of Research Financial Strategies in Rockville, Md. (“Long” means owning the stock, betting the price will go up.)

But ETFs, especially in the hands of individual investors, have the potential for big problems.

One is over-trading. For a long time, trading commissions were the biggest barrier to individual ownership of ETFs. If you wanted to build an ETF account over time, you’d have to pay a commission each time you made a purchase. But many discount brokers will let you trade ETFs for $9 or less — and Charles Schwab, the largest discount brokerage, will let you trade ETFs for no commission at all. (Most discount brokers will allow you to reinvest dividends for free.)

And that’s where some of the problems with ETFs come in.

Tempting but treacherous

Sometimes the temptation to trade overcomes investors’ common sense, says Jim Lowell, founding editor of the ETF Trader, a newsletter. Vanguard founder John Bogle has been an outspoken opponent of ETFs for that very reason: Investors tend to be their own worst enemies when it comes to trading ETFs. (Vanguard offers both traditional funds and ETFs, although its ETFs were introduced after Bogle had stepped down as CEO.)

Wall Street hasn’t helped, offering funds with outsize returns and outsize losses. For example:

Leveraged funds.

These funds promise to give you twice the return — on a daily basis — as the underlying index.

ProFunds Ultrabull ETF, for example, aims to give investors twice the daily gain or loss from the S&P 500. Direxion offers funds that will give you three times the daily return of their underlying indexes. It sounds great, but when the market moves against you, losses can add up quickly. Last year, the worst-performing fund was Direxion Daily Financial Bear 3X Shares, which plunged 95%.

What’s worse is that many leveraged funds aim only to produce their returns on a daily basis, rather than over the long term. It’s entirely possible, for example, for a leveraged long fund to produce a loss in a bull market. Losses in some leveraged ETFs have been so alarming that the Securities and Exchange Commission and FINRA, the financial services self-regulatory agency, have put out an investor alert about them.

The funds can be very lucrative for the companies that offer them, however. Direxion, for example, attracted $8 billion in assets in seven months when it rolled out its triple-leveraged funds, Lowell says.

Specialty funds.

Investors can choose from more than 900 ETFs, and some new offerings are highly specialized, to say the least.

“They’re slicing the baloney thinner and thinner,” says Burt Greenwald, a Philadelphia-based mutual fund consultant. You can now buy ETFs that specialize in timber, Canadian energy stocks, water, the Swedish krona and Chinese real estate.

Investors are often lured in by outsize gains of highly specialized funds. The Market Vectors Coal ETF, for example, soared 144% last year, according to Morningstar, the mutual fund trackers. Highly specialized funds are not only volatile, but also thinly traded — which means that the funds’ share prices might not track the underlying index terribly well. Case in point: The United States Natural Gas fund fell more than 50% last year, even though natural gas prices rose slightly in 2009.

Actively managed funds.

The newest innovation: ETFs that have a portfolio manager. Unlike index funds, which are relatively easy to assess, investors in actively managed ETFs have to take a guess about the ability of the manager to perform well.

ETF Trader editor Lowell thinks that the growth in new funds is simply part of the evolution of a new industry.

“I love to see new ideas, and I love to see stupid ideas,” Lowell says. “Right now, we’re at the point where some form of natural selection is taking place.”

Last year, several ETFs were liquidated by their sponsors because they didn’t attract enough assets.

Not all of the growth in ETF assets is from individual investors. Professional money managers, too, are voracious ETF consumers: “Everyone from hedge funds to endowments, pensions and other mutual funds,” Fox says. The pros own half of the industry’s assets, says Strategic Insight.

One reason: convenience. Big institutional investors used to use money market securities, or cash, as a place to park new money until they could invest it in stocks. In a rising stock market, however, holding a big bundle of cash can hurt performance. A savvy fund manager can park excess cash in an ETF that roughly mirrors the fund’s benchmark.

Financial advisers — investment professionals who charge a fee to manage individual accounts — have grown extremely fond of ETFs, too.

Reutemann uses ETFs for his trend-following system of investment management.

“I don’t like individual stocks, and I don’t like mutual funds,” Reutemann says.

Costs are relatively low

One reason Reutemann, like many other managers, likes ETFs: low cost. Many advisers charge a percentage of the client’s assets to manage money, often as much as 1%. The average stock fund charges about 1.5% in fees. It’s tough to produce decent returns for clients when you’re taking 2.5% or more in expenses every year.

Many ETFs, however, charge 0.4% or less each year. Schwab U.S. Large-Cap ETF, the cheapest ETF, charges 0.08% a year — $8 on a $10,000 investment.

An adviser can keep a client’s portfolio in ETFs and still have lower expenses than many actively managed mutual funds. Advisers also like ETFs for hedging against market declines — and for giving investors exposure to areas that had long been either too risky or too expensive for ordinary investors.

You can buy ETFs that invest in physical commodities, such as gold, silver, platinum and palladium. SPDR GoldShares, which invests in gold bullion, has attracted $40.2 billion since its inception in November 2004.

Other ETFs invest in broad ranges of commodity futures. And you can now choose among more than 100 bond ETFs, including one that invests entirely in Treasury bills — effectively, an exchange traded money fund.

The powerful interest in ETFs from institutional investors and from individuals almost guarantees that the industry will continue to grow rapidly in the next 10 years, although perhaps not as rapidly as in the past 10 years. The biggest danger, however, is that in the rush to gather new assets, investors’ best interests will get overlooked.

For example, says MarketRiders’ Tuchman, many new index funds use indexes that have been created just for the fund. Without back data on how the index has performed over time, it’s hard to evaluate the fund.

And that trend makes him worry.

“If Wall Street can find a way to make money off the unsuspecting investor, it will,” Tuchman says.

* Rebalance shares the same investment platform as MarketRiders.

Sellers of Portfolios-To-Go May Become Wall Street’s Next Thundering Herd

…“I don’t have enough money that I have a dedicated wealth manager,” said Cohen, who lives in San Mateo, California, and his chief executive officer of Caring.com, which offers resources for children helping aging parents. “It got me a much more diversified portfolio than I could have ever done on my own.”

The next thundering herd on Wall Street may be the ranks of low-cost portfolio managers such as MarketRiders and FolioInvesting, which cater to self-directed investors like Cohen.Sites that sell prepackaged portfolios have attracted more than $3 billion in assets over the last three years as more investors leave their full-service brokers.

“Individual investors have started to realize they can actually do some things as self-directed investors reasonably well, if they’re given a platform that allows them to invest more intelligently,” said Steven Wallman, chief executive officer of Folio Investing, where investors can purchase predesigned and customized index portfolios for $29 a month.

Some of the firms, such as Flat Fee Portfolios, are too new to have any performance history. Market Riders can’t track the actual performance of its customers’ accounts, since it doesn’t have custody of their assets. Covestor and Wealthfront Inc.,which give users access to third-party investors, publish performance history for the managers they work with on their sites.

Performance History

“Who are the people that are advising me when I’m going to a faceless website?” said Chris Walters, head of wealth management for Pasadena, California-based Citizens Trust. He said investors should be concerned by the lack of performance history available from some of the firms.

Bank of America Corp. (BAC)’s Merrill Lynch and Morgan Stanley Smith Barney, the top two full-service brokerages by client assets, had combined outflows of about $150 billion during 2009,the most recent year for which data is available, and about 10,600 financial advisers left the firms that year, according to Aite Group, a Boston-based research firm. Merrill Lynch hasn’t seen a trend of investors leaving the broker, said Selena Morris, a spokeswoman for the bank.

Change in Focus:

The number one source of accounts is what we would refer to as full-commission brokers,” said Peter Sidebottom,executive vice president of product, marketing and client experience for Omaha, Nebraska-based TD Ameritrade HoldingCorp. (AMTD), which caters to do-it-yourself investors. Accounts with TD Ameritrade increased by 14 percent over the two years through December and assets are up 65 percent over the same period, to $386 billion.

Traditional brokerages are focusing more on their wealthiest clients in an effort to improve profitability, so the customers leaving these firms tend to be the ones with the smallest accounts, said Katharine Wolf, senior analyst for Cerulli Associates, a Boston-based research firm.

“They’re not looking to target a client that has, say,under $250,000 to invest,” she said.

Those investors are potential customers for services such as Flat Fee Portfolios, which began opening accounts in February. Clients with assets of less than $250,000 are offered several predesigned portfolios with an annual review for a feeof $129 a month.

It’s the “Wolfgang Puck Express” of portfolio management,said Mark Cortazzo, founder of Flat Fee Portfolios, referring to the celebrity chef who sells gourmet dishes for low prices as fast-food restaurants. The portfolios are managed by MacroConsulting Group in Parsippany, New Jersey.

Accessible Price

“It’s for people who want good quality asset management,”at a price that is “accessible to a much wider demographic,”he said. The firm charges $199 a month and provides semiannual reviews for accounts with at least $250,000.

At Hedgeable Inc., investors can choose from among 20 different exchange-traded fund or stock model portfolios. Fees for the service, which began opening accounts through its website in December, range from 0.75 percent to 1.5 percent. Investors like the transparency of the Web-based business models, said Mike Kane, founder of the New York-based firm.

“Traditionally in the investment advisory world you handover to your adviser say $100,000, and they invest it how they see fit. You meet with them once a quarter or once a year and you really don’t have any control beyond that,” Kane said. Hedgeable investors can view up-to-date account information including transactions and holdings on their mobile phones, he said.

E-Mail Exchange

Some of the services leave investors in control of their assets and others take discretionary authority over client accounts. With Flat Fee Portfolios, managers have discretion over client assets. MarketRiders gives advice on investment decisions, such as rebalancing, and investors may then choose whether to apply it to their own brokerage accounts. Other than Folio Investing, which is a broker-dealer, all of the firms are registered with the U.S. Securities and Exchange Commission as investment advisers.

“The beauty of it for me is that monthly e-mail that just says ‘Here’s how to do it,’” said Cohen, who has been using MarketRiders for about two years. “If I didn’t get that e-mail I’d never do it.”

Prepackaged portfolios from Folio Investing may contain individual stocks, mutual funds or exchange-traded funds. The McLean, Virginia-based company’s moderate portfolio for investors planning on retiring in 2040 is composed of 10 exchange-traded funds and notes that track stocks, real-estate investment trusts and commodities, including the PowerShares QQQ fund, which follows the Nasdaq-100 stock index.

Viewable Actions

That portfolio returned 3 percent annualized over the three years to April 6, compared with average returns of 1.3 percent for 2040 target-date mutual funds, according to Folio Investing and data from Chicago-based research firm Morning star Inc.

Covestor, which began managing money in November 2009,tracks the portfolios of about 30,000 users who choose to make their investment actions viewable to others on the site, and users may have their accounts track the trades of about 150 pre-screened managers on the site.

“It’s like an open-source hedge fund,” said Perry Blacher, chief executive officer of London-based Covestor. Some of the managers on the Covestor site are professional investment advisers registered with the SEC and some aren’t. The managers range from Atlas Capital Advisors, a San Francisco-based registered investment adviser that manages $175 million for high-net-worth investors, to “an ophthalmologist in Wisconsin,” Blacher said.

Global Reach

“Investors should always be very careful to check out the people providing investment advice,” said Patricia Struck, administrator for the division of securities of the Wisconsin Department of Financial Institutions, “especially when what they’re giving you is not tailored to your needs.” SEC spokeswoman Florence Harmon declined to comment on the Covestor business model.

These sites don’t represent a competitive threat to traditional brokerages, said Jim Wiggins, a spokesman for MorganStanley (MS) Smith Barney.

“People don’t come to Morgan Stanley Smith Barney for discount trading,” he said. “They come for professional money management and to access some of the products and services that are only available through a global investment bank.” He declined to provide the range of fees full-service brokerage customers pay.

‘Cookie-Cutter Approach’

MarketRiders, based in Palo Alto, California, has $2.7billion in user portfolios. Traditional brokerages had about$4.7 trillion in assets under management at the end of 2009 and account for about 38 percent of all U.S. wealth-management assets, according to Aite data. Folio Investing, which is closely held, has “multiple billions” invested, said Wallman,who wouldn’t provide a specific figure. Covestor’s Blacher, who wouldn’t disclose assets, said the company is gaining about 15 percent in assets each month.

“I have yet to see a cookie-cutter approach that is as appropriate as a customized approach, and that’s what you give up when you go to one of these types of services,” said Walters of CitizensTrust, which is the wealth-management division of Ontario, California-based Citizens Business Bank. Walters’s firm has an average client account size of $4 million.

Mass Management

Wealthfront, which started in October 2009, lets users invest as little as $10,000 among 40 different registered investment advisers who normally have account minimums of $1million. The firm has about $180 million in assets invested through its site.

“We’re trying to deliver institutional-class asset management to the masses,” said Andy Rachleff, chief executive officer of Palo Alto, California-based Wealthfront. He said the firm chooses investment managers to participate the same way endowments do, by examining managers’ historical trade details rather than just their performance history. Rachleff is the vice chairman of the University of Pennsylvania’s endowment investment committee.

Wealthfront managers have returned an average of 30 percent from the site’s start in October 2009 through Feb. 18, compared with a 27 percent gain in the Standard Poor’s 500 Index. The managers charge average fees of 1.3 percent.

Richard Ferri, founder of Troy, Michigan-based Portfolio Solutions, builds index fund and exchange-traded fund portfolios for clients and rebalances them periodically for a fee of 25 basis points. A basis point is 0.01 percentage point.Rebalancing during times of market turmoil may add about one percentage point to returns annually, he said. The firm has almost $1 billion in assets under management.

Saving Money

Investors could save more money on their investments and improve their returns by skipping services such as Market Riders and making decisions themselves, said Burton Malkiel, professor of economics at Princeton University and author of “A RandomWalk Down Wall Street.” The 10th edition of the book was published in January.

He recommends investors hold a mix of the Vanguard Total World Stock Index exchange-traded fund and a broad-market bond exchange-traded fund such as the iShares Barclays Aggregate BondFund (AGG) or the Vanguard Total Bond Market exchange-traded fund, and rebalance annually.

“I don’t want to pay 25 basis points to anybody to do that for me,” said Malkiel.

Barron's: Do-It-Yourself Portfolio Management

Many of us woke up New Year’s Day wondering where the heck our investment portfolios had gone, and why, once again, we had failed to learn the lesson of prior market crashes: Even the smart money sometimes is dumb, including the pros to whom we entrust our money.

If the past year’s returns are as good as Wall Street’s best and brightest can do, you might as well do it yourself, says Mitchell Tuchman, CEO of MarketRiders, a new investment-advisory service for D-I-Y investors. At the very least, spreading your dough across the right mix of “passive” exchange-traded funds, says Tuchman, will save you the return-killing fees and taxes that come from investing with active fund managers.

We small fry trust money managers in the first place because we lack the time, expertise, confidence and computer models to build properly diversified portfolios ourselves. That’s what MarketRiders E.Adviser provides, as do similar services from discount brokers E*Trade and TD Ameritrade. They crunch the numbers and make asset-allocation recommendations for a nominal fee.

Loosely grounded in Modern Portfolio Theory, with its emphasis on minimizing risk through diversification, these services follow in the footsteps of Financial Engines, which pioneered MPT portfolio-building for retail investors in 1998. Financial Engines now offers optimal portfolio allocations for a million investors, mostly through 401(k) plans. Non-plan investors can use the services for about $150 a year.

MarketRiders E.Adviser costs $100 annually and, unlike Financial Engines, recommends exchange-traded funds exclusively. Building a portfolio with E.Advisor takes just minutes. You answer a few questions about your risk tolerance and investment horizon, and E.Advisor suggests an asset allocation. Alternatively, you can use a ready-made portfolio template and add your current holdings.

Portfolios of $100,000 or more offer the best balance between diversification and cost reduction. Select a brief seven-year time horizon (to increase difficulty) and medium risk tolerance, and E.Advisor suggests its Moderate Risk- Bonds Portfolio with an allocation of 41% bonds, 25% U.S. equities, 11.5% developed- country equities, 9% inflation-protected bonds, 8% real estate and 5.5% emerging markets. Funds are spread across 15 ETFs culled from a list of 800 funds MarketRiders has pre-screened to maximize liquidity and minimize cost.

Again, to reduce costs, MarketRiders recommends using a discount broker such as E*Trade or TD Ameritrade to execute trades. All trades are reported to E.Adviser, which tracks your portfolio’s progress and alerts you by e-mail when it’s time to rebalance. Including the E.Adviser subscription and an annual management fee of 0.17% of assets invested to ETF providers, Moderate Risk- Bonds costs about $166 a year. MarketRiders figures a comparable collection of actively traded mutual funds would cost about $1,500 a year.

A backtest of this portfolio shows it would have lost 13.89% in the past 12 months. Sounds pretty bad until you consider how you might have fared on your own. During that time, the Dow Jones Industrial Average fell 22.97%, the S&P 500 25.36%, and world markets 29.92%, according to MarketRiders’ calculations. The Vanguard Total Bond Market (ticker: BND) ETF was up 6.16%. But would you have been sufficiently prescient to have moved all your money into bonds in July 2008? Was the average active manager?

Study after study shows that few active managers meet or beat their indexes in any year, much less two in a row. But neither do individual stockpickers. Dalbar’s annual Quantitative Analysis of Investor Behavior figures the average undirected investor trying to time the market usually underperforms it by about 7%, even before trading costs and taxes. Pennies saved with ETFs may be the only pennies earned by a lot of us.

And there’s another key benefit of ETFs: Even small dollar amounts can be invested, and in logistically challenging asset classes such as real estate, currencies and commodities. Instead of illiquid real estate, the Moderate Risk- Bonds Portfolio recommends the highly tradable SPDR DJ Wilshire REIT (RWR) and SPDR DJ Wilshire International Real Estate (RWX) funds.

Both TH Ameritrade and E*Trade will design portfolios for you that mix individual stocks, bonds, certificates of deposit or almost any other investment. But you can opt for an all-ETF portfolio, including one designed by the companies’ advisors. E*Trade’s Online Advisor offers six investing alternatives, five of which are managed by E*Trade specialists and require minimum investments of $10,000 to $250,000; advisory fees start at 0.5% of portfolio value. E*Trade’s self-directed portfolio requires no minimum investment, and your only costs are trading fees.

The comparable self-directed Amerivest service requires a $25,000 minimum, and annual fees that start at 0.75% of the first $100,000. Nearly all the service’s allocations have trailed its benchmark for the past five years, however. Amerivest will execute the trades necessary to maintain your allocation percentages without charging you commissions.

Both brokerages require that your assets reside with them. Even current TD Ameritrade customers have to open a new account funded with cash, not current TD Ameritrade holdings, to use the service. Bottom line: These are gateway solutions whose overriding goal is to generate new customers and assets under management. They’re best suited to investors looking for a new broker. MarketRiders and Financial Engines, on the other hand, are pay-for-play solutions with greater ease of use and depth. Financial Engines offers more rigorous statistical analysis, but that won’t necessarily guarantee better returns.

Here’s the problem with MPT (and all other investment strategies): September 2008 or March 2001 or October 1987. Pick your favorite market meltdown, any market meltdown. As Nassim Nicholas Taleb observed in his 2007 bestseller The Black Swan, the game-changing events of these years didn’t fit the statistical models.

As most investors learned last year, it’s just about impossible to immunize yourself against market disasters. But proper asset allocation can help minimize the pain.

Are Your Funds Keeping You from Becoming A Millionaire?

Mutual funds can drain upwards of $1 million from an investor’s retirement savings over the course of several decades, according to a recent study. The study, conducted by MarketRiders, a company whose website helps investors build exchange-traded fund portfolios, provides a unique long-term glimpse into the corrosive effect of mutual funds’ fees.

[See U.S. News’s list of the Best Mutual Funds for 2010, and use our Mutual Fund Score to find the best investments for you.]

“Fees are recurring revenue [for fund companies],” says MarketRiders CEO Mitch Tuchman. “They’re just siphoned out of accounts in ways that one cannot [easily] see. It’s an insidious process.”

In the study, Tuchman created two individual retirement accounts: one comprised entirely of ETFs and the other entirely of mutual funds. Both portfolios had a starting value of $100,000. Tuchman assumed that a hypothetical investor contributed $4,000 annually to each IRA and that each portfolio returned 7.5 percent annually.

If an investor began contributing at age 35, the mutual fund portfolio would be worth $2.04 million by the time he reached age 76. The ETF portfolio, meanwhile, would be worth a whopping $3.15 million.

Each IRA consisted of 21 funds that gave investors broad exposure to stocks and bonds, both foreign and domestic. In the mutual fund portfolio, the average expense ratio was 1.39 percent. In the ETF portfolio, it was just 0.21 percent.

Tuchman says that investors tend to misjudge the cumulative impact that fees can have. “They think, ‘It’s just 1 percent or 1.5 percent; what’s the big deal?’” he says. “It sounds like a small amount, but it’s of all of your money, [and it’s] every year.”

While Tuchman’s numbers are certainly striking, there are a number of wrinkles in the study. For starters, he compares actively managed mutual funds with ETFs and assumes equal performance over time.

This is problematic because the whole point of actively managed mutual funds is that they are supposed to beat their benchmark indexes. The way Tuchman sees it, therein lies the problem. In other words, he contends that over the long haul, a large portfolio of expensive, actively managed mutual funds can never be expected to beat (after management costs are factored in) a comparable ETF portfolio.

“When you compound it and look at it over long periods of time…then you say, ‘Well, how can fund managers overcome that kind of a handicap?’ And the truth is, they can’t; they don’t,” he says. “That’s the whole joke of the beat-the-market crowd when they’re helping people invest for retirement.”

Certainly, though, there are a number of active funds that consistently trounce their ETF counterparts. But even if that weren’t the case, if an investor is to assume that ETFs and mutual funds are going to get the same annual returns, then it would be more apt to compare ETFs with index mutual funds than it would to be to match them up against active funds. After all, index funds are often far less expensive than their active counterparts.

For instance, one of the funds in Tuchman’s ETF portfolio is Vanguard Total Bond Market (BND), which has an expense ratio of 0.1 percent. In the mutual fund portfolio, Tuchman swaps out BND and replaces it with C shares of Eaton Vance Strategic Income (ECSIX). The C shares of the Eaton Vance fund come with an expense ratio of 1.83 percent. But BND has a mutual fund sibling, the Vanguard Total Bond Market Index (VBMFX), which carries an expense ratio of just 0.22 percent.

Admittedly, the ETF option still has a more favorable expense ratio. But there are other costs to factor in, too. The most important of them is that in most cases, ETF investors need to pay a commission each time they make a trade. For investors who make small, monthly contributions to a diversified retirement portfolio, these transaction costs could be far more corrosive than mutual fund fees. In fact, they would be “cost prohibitive,” says Paul Justice, an ETF analyst with Morningstar.

On the other hand, investors who contribute just once a year, particularly to a more compact portfolio (i.e., fewer trades are involved), can often absorb these commissions and still come out ahead. Either way, though, the MarketRiders study doesn’t account for commissions.

So when it comes down to it, investors should still be asking themselves the same old questions: Can actively managed funds add value? If not, is it more practical to invest in an index mutual fund or in an ETF? The answers to these questions, of course, are highly personal, and there’s no one-size-fits-all equation.

Another interesting set of statistics from the MarketRiders study illustrates how much more money investors can earn if they get an early start to saving for retirement. Remember the investor mentioned above whose mutual fund portfolio would be worth $2.04 million when he reached age 76? Well, if he began contributing at age 45 as opposed to 35, the portfolio would be worth $1.1 million instead, according to Tuchman. And if he started at 55, it would be worth just $577,000.

But with more than 800 ETFs on the market, choosing which funds to buy has become more difficult. And for a portfolio with a mix of funds, maintaining target asset allocations as the values of various holdings shift can get complicated.

Some online services from brokerage firms and others can help with both tasks, although the assistance typically comes at a cost. Here’s a sampling of what’s available from various providers:

The online brokerage firm Foliofn Investments Inc., founded in 1998 by Steven Wallman, a former commissioner of the Securities and Exchange Commission, aims to make it easy to create and manage portfolios of multiple securities. While the original focus was on individual stocks, the approach is an excellent fit for ETFs.

Users of the site invest in portfolios, or “folios,” comprising as many as 100 ETFs, stocks or other holdings.

You can create your own folios or pick from more than 100 suggestions. The site makes it easy to rebalance back to your original allocation targets and to stick with that allocation plan as you invest additional dollars or withdraw money from your account.

Say, for instance, you invest $10,000 in a six-ETF folio, including 40% in an ETF tracking the Standard & Poor’s 500-stock index. If you want to invest an additional $1,000, one click will spread your dollars among the six ETFs according to your target allocations, including $400 to that S&P 500 fund.

But maybe U.S. stocks have risen more than other holdings recently, so that S&P fund has grown to be larger than 40% of your portfolio. You could, with a single click, request to have your new contribution distributed so that it nudges your portfolio back toward your allocation targets, which would mean putting less than 40% of the new dollars into the S&P 500 fund.

The site also makes it easy to rebalance a folio back to its target mix by moving dollars from some holdings to others. Investors can get alerts to keep them on track.

Folio Investing offers its own predesigned folios of ETFs and some created by outside providers. For instance, the firm’s retirement-focused Target Date folios of ETFs come in 24 varieties—offering target retirement dates at five-year intervals as well as three levels of risk (conservative, moderate and aggressive) for each target date. The 7Twelve Life Stage folios designed by Brigham Young University professor Craig Israelsen each use 12 funds to give exposure to a total of seven broad asset classes.

Partners are vetted before their portfolios are featured, but Folio Investing offers no opinion on the offerings or their allocations, says Mr. Wallman.

ETF investors willing to let their trades be processed only at designated times during the day, starting at 11 a.m. and 2 p.m., pay $4 for each ETF bought or sold. Market orders executed at other times cost $10 each, and there’s a $15 quarterly fee if fewer than four trades are made.

Alternatively, users can pay $29 a month or $290 a year for unlimited trades processed during the two designated time periods.

MarketRiders

This site is designed to help investors create and manage ETF portfolios exclusively. MarketRiders, founded in 2008 by entrepreneur and investor Mitch Tuchman, isn’t a brokerage firm. Users execute trades through the online broker of their choice and then input the trades into the MarketRiders system; the site tracks the portfolio, updating prices daily, and sends email alerts for periodic rebalancing.

Users start by creating a portfolio. MarketRiders suggests portfolios using mostly funds from Vanguard Group and BlackRock Inc.’s iShares unit, with the allocation based on the user’s answers to questions about age, investment horizon and risk tolerance. For instance, a 40-year-old with a moderate risk tolerance and an investment horizon of more than 10 years was shown a suggested portfolio of 14 ETFs spanning several asset classes, including real estate and gold.

The company also offers a do-it-yourself option, which suggests asset-allocation levels and ETFs for each asset class but then gives users the opportunity to personalize the portfolio.

MarketRiders says that in a “normal” market, users are likely to get two to four rebalancing alerts a year. But you can adjust the settings so that a smaller or bigger change in portfolio values triggers those email notices.

The site charges $9.95 a month or $99.95 per year.

ING Direct ShareBuilder

This site, run by a unit of ING Group NV,

is geared to no-frills, buy-and-hold investors who want to add money to their portfolios at regular intervals. The PortfolioBuilder tool was among the easiest to set up of those reviewed here.

For scheduled investments in stocks, mutual funds and ETFs, ShareBuilder charges $4 per trade or $12 per month for six trades or $20 per month for 20 trades. Unscheduled trades are $9.95 each.

Need guidance on which ETFs to buy? ShareBuilder’s brief questionnaire places investors into one of five risk profiles, and account holders can get a suggested portfolio of no more than six ETFs from the iShares lineup. Portfolios can have as few as two ETFs.

Rebalancing isn’t automatic, nor is there an alert system.

E*Trade

E*Trade Financial Corp., like a number of other brokerage firms, will manage portfolios of ETFs for investors for a fee. But investors can also use the firm’s Online Advisor tool to get a recommended portfolio of ETFs at no charge. Trades are subject to commission charges starting at $9.99 for an ETF.

The Online Advisor tool involves answering a longer-than-usual investor survey—with questions about how much money you have, your risk tolerance, when you expect to draw down the money and what you are saving for. Visitors who aren’t registered on the site as customers are asked to supply their names and contact information in order to see the recommended portfolio.

E*Trade then responds with one of seven asset-allocation portfolios using as few as five ETFs, mostly iShares and Vanguard offerings as well as the SPDR S&P 500 fund.

The Online Advisor is tougher to navigate than other tools surveyed. For one thing, if the tool decides from your survey answers that you have a low risk tolerance, you have to redo the entire survey to see how its recommendations would differ for a moderate or high risk tolerance—and figuring out which answers would alter its assessment of your risk tolerance is a guessing game.

Also, while E*Trade says it sends out annual reminders for investors to check their allocations, the service doesn’t include an allocation alert if the portfolio gets out of whack between reminders.

TD Ameritrade

On this site from TD Ameritrade Holding Corp., which offers a range of services, click on the Planning & Retirement tab, then on Portfolio Guidance to see portfolio services.

The Self-Directed Amerivest option allows users to complete a questionnaire and see a suggested portfolio of ETFs based on one of five risk profiles. You can customize the portfolio by using some different ETFs from those that are recommended. Investors can choose to have their portfolios automatically rebalanced at regular intervals. They can also choose to have new investment dollars automatically directed to bring allocations back in line.

Target-date portfolios of ETFs are also available.

Investors using these two portfolio services pay no commissions for trades. Instead they pay fees starting at 0.75% of the amount invested up to $100,000 and dropping for higher amounts. A minimum investment of $25,000 is required.

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