The risk of not knowing what’s inside of a fund investment is one which has shown a very consistent history for causing problems. From money-market funds and guaranteed deposit investments to mutual funds, not knowing the contents of an investment fund has proven to be disastrous, particularly over the last 10 years.

As such, we need to have a way available to fill in the gaps that an investment adviser leaves us with when we are evaluating an investment decision. Specifically, when we are stuck with a summary of a mutual fund position that is highly recommended, but composed of nothing but other mutual funds, we need to know how to follow up with our own research to understand exactly what’s going on behind the curtain.

The first step to digging into a fund-of-funds position is to look at what the individual investments are in the company, and to determine what class of investment they are. Are these the same ‘investor’ class funds that are available to any individual on their own for a reasonable investment amount, or are they ‘ adviser’ or ‘institutional’ class shares that require large initial investment amounts.

More often than not, a fund-of-funds will contain institutional class fund units, because they allow the advising company to take advantage of the scaling of the larger shares, and then pass on some savings to their customers. It is therefore very important for us to understand this aspect of the held funds, because the difference is enough to impact our investment decision (why pay an advisory fee for a mutual fund that we can buy on our own? We want to focus in on the institutional-scale that creates savings for our portfolios).

Upon determining the type of position that’s held in our potential investment, we can then start to investigate the actual holdings of the position by searching out institutional fund through a tool like Morningstar or yahoo finance. These tools will allow us to look at a very detailed summary of the fund itself, and also provide links to the actual fund prospectus for those nosy investors that want the most specific details.

The information that we are most interested in from these summaries is the holdings data. Specifically, we want to catalog the weightings of specific positions inside the held fund. We will do this for every single position that is within the fund of funds, which means that we’ll probably wind up with a very extensive list of securities that are being held throughout the entire position.

The final step in examining a fund of funds (at least in this particular situation) is to investigate the individual holdings for duplicate positions, and for over-weighted positions. For example, a blue-chip mutual fund that holds multiple fund-portfolios of blue-chip stocks will likely have overlap between its holdings. The risk here is that the purchased mutual fund will wind up over-exposed to a specific blue chip position, to the point at which the fund is unbalanced.

Realistically, why would an investor want to purchase a mutual fund that is overlapping to the point at which it is really only exposed to 10 stocks, when they can simply buy those 10 positions on their own and not pay the mutual fund fee? The end result is that we will have an understanding of the full exposure of the investment opportunity, and will be able to make a fully educated decision about how it is that it fits within our existing portfolio.

There is an interesting trend occurring in the advisory business right now that leaves a sour taste in my mouth. As the industry grows internationally, and the sophistication of the research required to maintain an investment portfolio such as a mutual find increases due to a complex investment industry, advisers are becoming further and further detached from the products they discuss with their clients.

While they will maintain a professional level of understanding that empowers them to discuss the impacts of a particular position on a client’s portfolio, it is becoming increasingly macro-focused, to the point at which I’m concerned that there is a growing detachment from the fundamental understanding that is arguably necessary to advise a client. Specifically, I’m seeing more and more situations where a financial adviser not only doesn’t know which individual securities are invested within a particular mutual fund, but they don’t even have access to that information. While we can go into greater detail about why it is that this information is important, this article is going to instead focus in on the question of why it is that advisers are missing this information, and what it means for a personal investor.

In general, a financial adviser has a duty to understand their client’s financial need, and to understand how it is that a recommended investment could build or diminish value in that particular client’s portfolio. This is why they take so much time discussing the various holdings of their clients, their plans, and even their personal habits, so that they can tailor their advice as much as possible. However, when it comes to screening investment opportunities for clients, the adviser is not actually the one that makes the decision about which investments are actually available for distribution, the analysts are. It is the job of the adviser to understand and manage the client, and this is a full time position.

The way to then support a full time adviser with quality investment products is to have an in-house team of analysts backing up the adviser with full time investment research. So long as these analysts are a part of the same company as the adviser, the adviser is allowed to take their research and recommendations at face value, and to recommend based off of the entire company’s intellectual capacity. While this enables the company to conduct a stronger quality of research (because they can task the research to multiple people and levels of resources), it puts the adviser in a position where they experience greater and greater amounts of information-dilution.

Analysts provide advisers with summary documents which they can use to discuss opportunities with their clients, and the adviser is able to use the limited information to make a high quality investment decision based on the information provided by the investment analyst. However, because of the increasing sophistication of investment fund investments, the dilution of information is getting to the point at which an adviser is almost advising on nothing but thin air.

A mutual fund summary document for a professional adviser will usually consist of a discussion of the risk profile, the historic returns, and the general exposures of the fund itself. It will list the top ten holdings of the fund, and will discuss percentage exposures to various asset classes. However, as diversification intensifies within funds, it is coming to the point at which many mutual funds consist of actual positions in other mutual funds, which all the fund to diversify and scale itself in a way that meets the personal investor’s need for high-level diversification.

However, the poor investment adviser is now stuck with a document that shows them historical returns, percentage industry exposures, and a list of holdings that simply shows 10 other mutual funds, and no discussion of what their holdings are. For all the adviser knows, these investment funds are all full of garbage-grade positions that are ready to explode. They are therefore stuck going on nothing but the wink-and-nod of the analyst upstairs (or perhaps even upstate), and hoping for the best. Worse yet, when a client then goes so far as to ask an intelligent question, they are forced to rely more on salesmanship than rationality in explaining their way out of the informational vacuum.

The trend is clear, stigmatization and dilution of information that is being presented to investment advisers is a risk. However, there are ways to dig deeper into the summaries that we’re provided by these companies, so that we can complete our own internal due diligence on our personal investment portfolios.

Having looked at how it is that different indexing strategies can create different levels of returns on the same basket of securities, we can now start to dig in, and look at how each indexing method implies a different investment opportunity. In doing so, we can then evaluate the contexts in which these investments would prove to be appealing, or dangerous.

The first step to evaluate the impact of indexing strategies as they relate to a particular basket of securities is to investigate the fundamental nature of these investments. Specifically, we need to understand the price, liquidity, market cap, volatility, and yield-nature of the underlying securities. From there, we can analyze how it is that these traits will impact an indexing strategy in accordance to their similarities.

For example, a basket of securities that is exposed to a handful of highly liquid large-cap securities that don’t pay a dividend, and don’t pay a dividend will receive a bias from a price weighted and market-weighted index. As such, if these positions are expected to perform well into the near term, perhaps because of a change in interest rates, the price or market weighted indexes would out-perform the equal weighted alternative. However, if perhaps the opposite adjustment were to ensue (perhaps interest rates go down instead of up), the other mid-cap securities that don’t have as much leverage, but have a yield will likely appreciate, and therefore receive a bias from the equally weighted index.

Upon having taken a look at how it is that the basket breaks down in terms of its aspects, we can then start to look at the kind of exposure that our investment portfolio is looking for. This is where things start to get interesting, because it shows how we can create offsetting positions using the same basket of securities, perhaps through different mutual funds or ETFs. By digging into the specifics of exactly how it is that the index is generating its returns metrics, we can start to see opportunities for investment that either restrict or expand our exposure. For example, an ETF that follows a price-weighted index through the use of futures positions will not receive any dividends from yield-paying securities within the basket.

This means that the ETF should be priced at a discount to the actual basket, because it will be forgoing interest exposure. This is useful for an investor that is trying to create an inexpensive protective position by allowing them to short-sell the ETF without having to pay out expensive dividends every few months. For example, a land-lord that is concerned about interest rates could short-sell a synthetic REIT ETF that indexes housing prices for rental properties in a given market, but doesn’t pay a dividend. This position could offset the losses that the landlord experiences on his properties when interest rates go up, without requiring him to pay out the expensive yield of the REIT. This is as opposed to an equally weighted index that holds the actual REIT positions, and pays a yield.

Between the fundamental aspects of the index itself, in terms of pricing, market cap, liquidity, and yield, and the composition of an index itself, there is plenty of room for investors to make up a sophisticated investment position using what is commonly just a metric for comparison.

A market weighted indexing strategy is one which values the change in the total market capitalization of a basket of securities over a period of time. This means that the index will look at the total amount of value that has been created in the portfolio, regardless of whether the value creation comes from smaller or larger positions. The benefits of this sort of strategy is that it will provide an investor with a much more fair representation of how it is that the basket of securities is growing, and therefore provide an relatively unbiased indicator of growth. However, it is not a simple calculation to make, and its composition will still require a basic level of understanding to utilize in a practical way.

Since a market-weighted composition will take into consideration the market capitalization of a basket of securities, it will provide us with a good indication of the dollar value that is being created by companies in the fund. This is because of the way in which a dollar of growth in terms of market-cap represents a dollar increase in the value of the actual company itself, as opposed to a percentage change. The end result is a metric that combines the growth of all of the underlying securities into a single growth engine that is producing returns harmoniously. This is as opposed to something like a price-weighted index, which will place an artificial bias on larger securities by nature of the composition itself.

The trick to understanding a market weighted index is to remember that the market cap value, and therefore the value of the index, will change mainly to reflect adjustments in the stock prices of the underlying securities (which should ideally then reflect the value of the underlying company itself). However, this means that illiquid companies, or those which are closely held by insiders, or those companies that are closely held by only a few key investors will have less of an impact on the index because shares in those companies will trade less than those that are more widely held. As such, the liquidity of the more diversely held companies will create a more accurate representation of the value of the market cap of the broadly held positions.

That being said, just because a position’s price does not accurately reflect its value right away does not mean that the market cap should not adjust over time (and therefore create returns for the index). The trick to keeping track of a market-weighted index is to therefore keep track of the closely held and illiquid position to see if there are any value discrepancies present in the index against fundamental value. If there is a significant discount in the stock price of the illiquid positions against their tangible values, it is possible that a liquidity-event will later unlock value for shareholders in a way that will create tangible returns for index holders.

An equal weighted indexing strategy is one which averages out the returns of a given basket of securities in accordance to the number of securities in that grouping. This means that changes in the price of each position is taken into equal consideration, but that a bias is created for smaller growth-oriented stocks. Between the small-cap bias and the tendency to ignore the distributions that larger companies make, and then tendency of small company to grow at a faster rate than large companies, an investor should take the time to figure out exactly where it is that the short-comings of this strategy will manifest, and how it is that they can be mitigated as an investment position.

The small-cap bias of an equal weighted indexing strategy comes from the nature of small cap growth. Since a penny earned on a smaller stock will be worth more (in percentage terms) than a penny gained on a large-cap stock, combined with the sheer volatility of smaller stocks, an equal-weighted index will show greater exposure to its small-capped positions, even though changes in the larger positions are equally large in terms of dollar value.

Furthermore, this issue becomes even more apparent when we take into consideration that the larger companies in the index will generally be paying out some form of dividend, which will incrementally reduce the stock price against the returns that are actually being paid out to investors. The end result is that the index will be much more correlated to the returns of small positions than it will be the total returns of the larger companies, and therefore make for the appearance of more volatility than there might actually be present in the portfolio.

Investors can plan around the small cap biases of an equally weighted indexing strategy by taking measures to adjust the portfolio for the nominal changes that are taking place within the price of the smaller securities, factoring in dividend payments, and then looking at the overall volatility of the position itself. The easiest way to do this is to compare the equally weighted index with the price-weighted index, and to see how it is that changes in the prices of the positions relate to the changes in the equal average of same portfolio. If both are moving in the same direction, and with the same magnitude, then there is evidence supporting the neutrality of the basket of securities.

However, if the price-weighted basket is moving up, and the equally-weighted basket is moving down, it suggests that perhaps the two indicators are showing their biases, and that the returns are better off calculated manually to ensure that we know what we’re looking at. This can be accomplished by adding the dividends paid back into the returns calculation, or by looking at the basket’s individual positions to see how it is that individual stocks are creating returns for the portfolio.

A price weighted index is a strategy that is used to catalog the returns of a basket of securities based on their respective prices. It does so by averaging the total price of the underlying securities by the quantity of securities available. The end result is that we have a metric that will track the changes in price of the portfolio, with a bias that favors changes in the more expensive positions, and disfavors those positions that pay a dividend or distribution. That being said, there is always a reason to take on a position that mirrors such a bias, and therefore an incentive to understand exactly what is going on behind the curtains in this sort of product.

Price weighted indexes will favor growth-stocks that have a high stock price (perhaps because of a smaller market cap) because every nominal change in the value of these securities will have a greater impact on the overall basket of securities. Think of it this way: the heaviest item on the plate will have the greatest impact on the price of lunch at a salad bar. Since these larger securities take up a greater proportion of space in the portfolio, they will automatically bias the portfolio.

Worse yet, the portfolio will also fail to take into consideration the returns that an investor realizes from dividends paid out from blue-chip positions. Since stock prices decrease proportionately to dividend payments, price-weighted indexes will actually show poor returns for dividend paying positions because they will show that the position lost value from dividend payments, even though the investor was actually pocketing those returns all along. The end result is an unrealistic bias towards highly leveraged growth companies that do not return value to shareholders.

The way to mitigate the assumptions of a price weighted investment position is to keep track of the missed returns, and to balance out the portfolio in a way that provides better exposure to the actual basket itself. This can be accomplished by manually tracking the dividend returns from the position, and inserting them into a manual calculation that corrects for yield returns. By adding the value of dividends paid over a period into the final value of an index’s value, an investor can see a better representation of what the index actually returned, and therefore make a better informed decision about the investment itself.

While the creation of this ‘total returns’ price index will provide an investor with better information about the opportunities associated with the index itself, we also need to investigate how it is that the index was formulated in the first place. For example, if the opportunity behind the investment index is a mutual fund or ETF position, we need to know if the fund’s returns are being created organically, or synthetically.

If the position is made up of managed futures that will synthetically replicate the returns of the market, the dividends will not be paid out to the holding investor, and it might be better off to take on a position that has exposure to the payouts. However, if the dividend payments somehow hold the position back are factored into the price of the derivatives that make up the portfolio in question, the investor might still have an incentive to purchase the synthetic fund, so long as the trade-off between the synthetic position and the organic one makes up for the net present value of the opportunity costs that are paid with respect to having the money paid out to the investor through the dividend, or realized through capital gains over the long term.