Okay, so where are we now? So we have just been through the logic of mean-variance optimization and we started with the premise of decreasing marginal utility, and follow that all the way to the concept of efficient portfolios, and talked about how you can sort of do this the hard way or the easy way. The hard way maybe has more potential to deliver a lot of diversification benefit, optimizing over lots of assets but your output is only as good as your input, and you have to bear that in mind. We talked about the easier approach of let's just say the valuated market index is efficient and just leave it at that, and there's some actual justification for taking that point of view or we can take the point of view that, well, okay, it's a good idea to be trading indices because of the problem of information asymmetries. Private information of raising transactions costs as Dr. Sokoloff showed. So if we're going to optimize over individual assets, why not have those individual assets be indices and then just optimize over those, so we can still keep our transactions costs down. So that's where we are and what I want to talk about next is, what are this assets that we can optimize over, that allow us to diversify across indices and basically, there are two types of assets that I want to talk about here. Number one is going to be your basic open-end mutual fund, let's call it mutual funds. You're going to say mutual fund but what I mean is an open-ended mutual fund, which I'll define in a second. Think about Fidelity Magellan, that kind of fund. The other is going to be an exchange traded fund with this assets that are now called ETFs. ETF, exchange traded fund. So those are the two things I want to talk about. Those really are the main workhorses of the robo advisor. It's going to be where they're going to be putting your money. So let's talk about each of these and see how they work, and how they're going to be appealing to the robo advisor. So first, mutual funds. So your open-end mutual fund has been around since the 1920s. It's a very simple idea. So if I have a mutual fund, then I'm managing money and if you want to invest with me, well, you can give me 10,000 bucks of your money to manage and then I would take your 10,000 bucks, I would put it in the fund. So now my fund is gotten bigger by 10,000 bucks and I got to go put your money to work by buying more shares or whatever it is I'm trading. What you get, you're going to get shares of the fund and at what price you're going get shares? Well, I'm going to calculate the per share value of my mutual fund. So I value the whole portfolio that I'm holding of all the different things, value it at the end of the day and come up with a dollar figure divided by the number of shares outstanding of the fund, and that ratio is the value per share of the fund, and that's the price that you're going to pay. So that's your classic open-end mutual fund. People call it open-end because your money is going right in the fund or coming out of the fund later when you want to get out. Your investment is directly making the fund bigger or smaller. Now, the mutual funds have been around for a long time now but this industry has changed tremendously over the past, let's say, over the past 40 years but especially, let's say, just in the past 10 years. I would say 10 or 15 years. This industry has changed the most and the change I am talking about is a transition from a world of active management to a world of passive management. So when I say active management, that's what it sounds like. You give me your money and I am going to actively manage it. I'm going to figure out which stocks are undervalued. I'm going to buy those. If they're overvalued, I'm going to sell them. I'm moving your money around the different possibilities, based on my research, my diligence that I'm doing and with the goal of giving you an enhanced return. I'm going to beat the market with my analysis and my trading skill. So that's active management. That was sort of the whole world of mutual funds if you go back 40 years but especially recently, people have been moving instead into index investment and for two reasons really. Number one, the track record of active managers has not been good on average. So in a given year, the fraction of active managers that beat the market is below half. Most of them don't beat the market. Part of this of course is they charge pretty big fees. You might pay one percent per year to your active manager to make his trades. Whereas, if you invested with an index fund they would charge you far less, right? You put your money just an S&P 500 index fund, you're not paying one, hoping not paying one percent, right? I hope you're not because you can get that for less than a tenth of a percent. That is, these index funds they're not doing much labor here. They're not doing a lot of research. They're not doing all this work. They would otherwise charge you for. They also not trading very much, right? Because they're just buying the index. So it's all going to be a lot cheaper and people have been convinced by that logic and money is moving from active management into indexing, okay? One thing that means is that these days in the mutual fund space you have a lot of choice, there are a lot of different index funds out there. So just not say, don't take my word for it go take a look at all the offerings at Vanguard, Fidelity, whatever mutual fund family you like. Take a look, you'll see a lot of different choices of index funds; country index funds, industry index funds, socially responsible index funds, where they have a screen, so screening in or screening out. Certain kinds of stocks based on some sense of what is more ethical then what else? Lots of index funds that you can choose from these days. Okay. Now so that's your open a mutual fund, but let me just make a couple of points here about opening mutual funds, I'm going to contrast with the ETFs in a second. Okay. Notice that, when you trade with an open-end mutual fund, you're putting money in the fund so your investment makes the fund trade, okay? Now that can be some amount of drain on the fund that people go in and out and going in and out, makes the fund trade because it has transactions costs, right? So there's that. There's also another thing which is that, if you want to invest in an open-end fund, there's only one time of day that they trade, which is the end of the day. So if in the middle of the day say, "Hey, I think now's the time to get in the market." Well, you can make an order for shares, but you're not actually buying shares until the end of the day. So whatever happens in the market for the rest of the day you're not getting, right? You're getting in at the end of the day. So bear that in mind too. Also, a given fund family is not necessarily going to be accessible from just any trading platform. Okay. Trading platforms can be sort of signed up with certain fund families and not other fund families, so you want to put money some fund, well, if your platform doesn't have it, well, then it's going to be tough. Not impossible, because you can contact the fund family directly. Well, you can do it, but it's just a bigger hassle. Finally, a mutual fund is generally going to have a minimum investment. You can't very often put just a $100 into an open-end fund. They tend to have a minimum of, at Vanguard I think their minimum is 3,000 bucks for anything. You've got to have 3,000 bucks, if don't you're not putting money in one of their funds, okay, until you can accumulate that much cash. All right. So that's the world of open-end funds. Now let's think about ETFs, Exchange-Traded Funds. Now, as the name indicates, these are funds whose shares trade on the exchange, okay? So they trade on the exchange. That means, when you buy shares of an ETF, you're not putting money in the fund, you're just buying shares from somebody else who's selling them, okay? Your money goes to the seller and you get the shares, but the fund itself is sitting there untouched. Okay. Your trade is of no consequence, direct consequence to the fund itself. Okay. So you're not making the fund trade. Now bear in mind, there is going to potentially be a transactions cost on the market. So maybe it's going to cost you a penny a share, maybe a few pennies a share to make this trade. So there's a transactions cost on the market, but you're not making the fund trade itself, okay? Also, another difference from the open-end fund is, because these shares are trading on the exchange, you can go in and out whenever the market is open, right? You can go in or out whenever the market is open. You don't have to just wait to the end of the day, right? So if you think right now, I think I like what's happening in the market, I like this news that came out, I think now is the time for trade, I can go in right now, or if I get worried right now I can get out right now. So you can trade whenever you want. Also, you could in principle just buy or sell one share. Now that's an odd thing to do in the market. I just as sort of it's possible, right? If the share cost 100 bucks, you could just buy one share and invest a 100 bucks. That is a doable thing, what's not a doable thing, the Vanguard, there you would just simply need 3,000 bucks or you just not investing at all, okay? So there's there's no minimum. Okay. Furthermore, because it's trading on the exchange, you can access it from any brokerage account. Any brokerage account you can trade stock trade and exchange. There's no problem, if you have a brokerage account you will be able to trade any ETF trading at the US. Okay. So if you take a look at what these robo-advisors are going to do, they're going to focus on the ETFs. They're going to focus on the ETFs because you have a whole range of ETFs to choose from. You can go in and out whenever. ETF fees are even lower than the index funds. For the most part, they're lower than the index funds offered by open-end funds, right? Because ETFs it's actually a little cheaper to run an ETF, it's logistics of it are cheaper than an actual fund, they can charge slightly lower fees. So the robo-advisors optimizing over, for the most part, these is ETFs. Because the ETF fees are so low, right? If you invested the robo-advisor, you are paying fees on fees, right? You're paying fee to the robo-advisor and you're paying a fee for the investment that they put you in. But the fees on the investments they put you in a really low, okay? So even you add those two things together, you're not talking about a lot much per year. You're not talking about, for example, whole percent per year, right? Because both those fees are pretty low, okay? There's just always more ETFs coming out. All right. So if the robo-advisor wants to optimize over a wide range of possibilities, well, there are about 200 new ETFs rolled out every year, with just every possible combination different sorts of indices that you might want to aim for. So the robo-advisor can sort of think at its level about how to allocate across these indices and there's going to be an ETF there to make that work, to take that to the basket. So this is what you're generally going to see in this space is that we're going to optimize with robo-advisor either you take the valuate it indexes efficient approach or you take as other approach you're going to optimize over indices and if you look at ETFs space, there's an index for everything. So that's a feasible thing to do too.
