Modern Portfolio Theory and ETFs

Passive investing can save you fees, taxes, and time
tl;drModern Portfolio Theory (MPT) is the idea that your portfolio should get the highest return for a given level of risk (or the lowest risk for an expected return). Passive investing is a strategy based on the principles of MPT that involves building a diversified portfolio of low-cost investments like Exchange Traded Funds (ETFs). Most robo-advisors also use this strategy. It offers several benefits over active investing, including lower cost, greater tax efficiency, and less time commitment.

What is Modern Portfolio Theory?

Modern portfolio theory (MPT) is a framework for understanding risk and return in investment portfolios. It’s based on the idea that investors should have portfolios that maximize return for a given level of risk, or that minimize risk for a given level of expected return.

The theory assumes people want to get the most return for their level of risk, or that people want to carry the least amount of risk for their level of expected returns. For example, if you are about to retire and so want a very low risk portfolio, then MPT would suggest that you’d still want to maximize the potential return for that level of risk. Likewise, if you are seeking an aggressively high return on your portfolio, perhaps because you are young and have a long investment timeline, then you’d want to pursue that strategy in a way that still minimizes risk.

One way of reducing risk is diversification. A diversified portfolio means a wide mix of assets, so, for example, if one stock drops a lot in value, your whole portfolio doesn’t drop a lot, too.

What is an Exchange Traded Fund?

Exchange Traded Funds (ETFs) are a type of investment that hold many assets, rather than just one. Instead of buying, say, 500 different individual stocks, you can invest in a single ETF that bundles those 500 stocks into one.

Investing in ETFs is an excellent way of applying Modern Portfolio Theory.

ETFs can minimize risk without sacrificing return. MPT suggests building a diversified portfolio of low-cost funds that track broad arrays of the market, like the S&P 500 index (”index” here means a “group” or a “basket” of stocks). Investing in an ETF that tracks the ~500 stocks in the S&P 500 means that your portfolio will seek to capture the average return on the broad market.

What that means is ETFs are passively managed. They simply track the prices of whatever is inside of them, rather than being actively managed by a someone like a fund manager.

Active investing can be expensive without you realizing how much you’re paying. A mutual fund manager might try to outperform the market, or time the market, or promise that their active management can beat passive management, but data show that active management often underperforms the market, especially when you take into account the other expenses involved. Most all robo-advisors do passive investing in a portfolio of ETFs.

What are some benefits of passive investing?

  • Lower fees. A mutual fund manager’s fees may seem small at 1% or so, but they can add up to a very large amount of money over time that you’ve paid to them out of your own portfolio. Think of it this way: if a mutual fund charges you 1%, that’s ten times more expensive than an ETF with an expense ratio is 0.1%. (Many ETFs charge even less).
  • More tax-efficient. ETFs don’t generate a lot of capital gains from active trading and selling of assets. On the other hand, a mutual fund or active manager can generate more capital gains tax because of the higher number of trades.
  • Less time-consuming. Active management can involve ongoing research and analysis, especially if you’re trying to do it yourself.