Many investors are shocked to learn that an apparently small annual portfolio cost of 2% will likely result in a 40% loss of wealth over twenty years. How could what looks to be such a small fee result in such a deleterious effect? A brief explanation may help.

For discussions sake, if you accept that a globally diversified portfolio across stocks and bonds will historically return around 8% annually, then 2% in fees represents a 25% tax on profits. Think of it this way. For every portfolio dollar earned, you are paying your investment partners twenty-five cents via seen and unseen fees lurking in your portfolio. Extrapolate this impact out over 20 years and you can watch your net worth shrivel before you eyes.

And, shockingly, a 2% fee drag is easily achieved in today’s wealth management marketplace. According to 2010 research performed by PriceMetrix Inc., the average annual fee collected by advisors on managed accounts was 1.32%. Furthermore, most of the dollars within these accounts were directed into mutual funds whose annual costs, according to studies, averaged 1%, a 2.32% annual bummer.

While some might argue that having drinks on hand is essential to a great party, everyone knows that a belligerent drunk quickly ruins an event. Likewise, fees are essential to investing, and you don’t want to hesitate paying for quality services and products. But when costs reach 2.32% they are out of hand and it’s time to call in the bouncer and clean up your portfolio act. Here is what to look for.

The cost of advice : Paying for investment advice makes a lot of sense for the majority of investors. A recent study by N. Scott Pritchard based on Dalbar research demonstrated that due to the erratic fear and greed based trading, the average investor underperforms the S&P 500 index by 6% annually. For this solitary reason, many will find the cost of going it alone is too high to bear. It behooves investors to take a hard look and decide if they have what it takes to do the long-term work of portfolio management without adult supervision.

This does not mean, however, that an investor should pay 1% for advisory services. One option for investors is to find an independent fee-only financial planner or investment adviser. For instance, the Garrett Planning Network has a nationwide association of professionals who are closely aligned with your interests and seek to make competent and objective decisions on an hourly, as-needed basis.

Additionally, you can also turn to one of several quality firms like Portfolio Solutions that will manage your low-cost and globally diversified portfolio for .25% annually. Or to firms like, MarketRiders, that will managed an account annually for a low fee annually. Getting professional advice can make a lot of sense, as long as you pay a reasonable rate for smart guidance.

The cost of your funds : The mutual fund promise is that high fees will be overcome through the outstanding performance of their funds. Sure, you will pay your annual 1% or more for fund participation, you will additionally pay hidden 12b-1 marketing fees, and you will experience difficult-to-track fees in the form of taxes that result from churn within the fund. But fear not!

Unfortunately, a closer looks at mutual fund performance over the decades should leave you with a different motto: Fear this!

Research has repeatedly demonstrated that mutual funds underperform their benchmark. At this point, this news has becoming so tragically boring that many seem to no longer be listening. Sadly, year-upon-year, a new batch of investors willingly piles off the mutual fund cliff and into the sea of high fees and poor returns. Those in the know remain bewildered as they look upon these sad lemmings plunging to their investment demise.

Smart investors looking to pay costs commensurate with value should look to low-cost Vanguard index funds and quality exchange-traded funds. These funds are essential building blocks for portfolio management and can now be had for absurdly low costs. Take, for instance, Vanguards S&P 500 Index Admiral Shares VFIAX -0.33% . This essential building block costs a meager 0.05%annually. A host of remarkable, low-fee ETFs from iShares, State Street Global Advisors, Schwab and more are also available to address your needs.

While risk and return make fabulous dance partners within your portfolio, keep a watchful eye on the belligerent party pooper — cost. If you’re a diligent bouncer and keep cost under control, you’ll be dancing with the stars in no time!

DFA has made the world of investing a much, much better place. Their index funds are low cost and highly competitive. DFA even argues that they possess better indexing skills and thus, achieve superior returns than its rivals.

But DFA is doing something even more revolutionary: DFA has convinced investors not to bet on a stock. Not even on a sector like utilities or technology, or even a country like China or Canada. DFA investors don’t want to bet on a few bonds in a laddered bond portfolio.

No, what DFA so brilliantly helps investors understand is that if you can just have confidence in the capital markets, your savings will grow in the fastest and safest way possible.

Capital ideas

This means, at the highest level, a bet on capitalism. When an investor loans money to a firm or government, or owns a part of an enterprise, he is entitled to his share of rewards for his capital. World markets reward investors for their capital and businesses and governments must compete with each other for investment capital. Investors in turn compete with each other to find the most attractive opportunities.

DFA educates us on why we should just focus on capturing our share of these returns at the lowest fee possible. Instead of thinking that Apple is mispriced, or developing our prediction of solar power, bet on capitalism. Over the years, capitalistic economies thrive.

It is a much better way to sleep at night and outperform most other investors. Once you have confidence that capital markets will grow over time, you can then leverage proven science to build a portfolio to capture your rightful returns. That’s where DFA has shown investors how to build a sophisticated portfolio that is truly diverse.

DFA has illuminated and implemented asset allocation strategies that heretofore were the domain of sophisticated endowments and pensions. Arming advisers with great tools for educating investors, DFA has helped many to leave the active “beat the market” circus, lower their fees, and diversify their savings.

Enter the ETF

For years, DFA was the only firm offering portfolios that harnesses this investment science, largely because they had all of the component funds at a low cost. But with the rise of ETFs, no longer is DFA the exclusive purveyor of this strategy.

DFA Funds are great. Their small and micro cap funds DFA U.S. 9-10 Small Company Portfolio, The DFA U.S. Small Company Portfolio and DFA U.S. Small Cap Value Portfolio have made investors about 10% yearly, compounded for about 20 years.

But low-cost ETFs now occupy every asset category offered by DFA. Investors who felt locked into a DFA set of products, are now able to build their own portfolios without going to a DFA adviser.

Moreover, DFA doesn’t always win in every asset class. Over the last five years in emerging markets equities, for example Vanguard MSCI Emerging Markets ETF  has outperformed DFA’s Emerging Markets Portfolio. DFA U.S. Small Cap Value has strong competition from iShares SmallCap 600 Value Index Fund.

Vanguard’s innovation was the index fund, and DFA took that to the next level with a marketing model to proliferate index fund portfolios. Now, widespread ETFs in every asset class and portfolio building software and expertise, takes DFA’s contributions to investing to every investor, not just those who can afford high-priced help.

A veritable horde of newly minted Facebook and Instagram millionaires has the wealth management industry frothing. By simply walking into the foyer of 555 California Street in San Francisco, the epicenter of elite firms, you will quickly witness the shift. Where just a few short years ago you found the scuffling feet of dreary wealth managers, you now witness a new, fervent energy as suited professionals dart about in search of their piece of this IPO pie. It was for moments like these that such financial experts hung their shingle by The Bay, and now, once again with billions of dollars in desperate need of management, the West Coast gold rush is on. Here is a word of advice to these nouveau riche.

Dear Young Silicon Valley Millionaire,

Congratulations for your part of a historic and remarkable accomplishment, the creation of technology that has forever changed the world and with it, your life. At this early juncture, the implications of this shift are hard to grasp, and yet on a personal level, the effects of your new wealth will reverberate into even the most remote corners of your life.

I speak to this coming change with authority, not simply as a wealth manager, but as a once successful entrepreneur and founding investor in and director of Baidu, the most successful IPO in stock market history. I too had to make the journey you now face and offer this simple and surprising guidance – listen to Google.

Yes, my advice is that you listen to Google’s advice. I know that Google is your great competitor, but in 2004 Google did something worthy of your attention.  Early that year before Google’s IPO, Senior Vice President Jonathan Rosenberg realized that he was about to spawn thousands of impetuous young millionaires, and feared that they might be preyed upon by the wealth management industry.  After consulting with founders Sergey Brin, Larry Page and CEO Eric Schmidt, he planned a series of in-house investment seminars to educate their soon-to-be wealthy colleagues. In the spirit of the “don’t be evil” Google ethos, management decided to invest in the preparation of their employees for the coming onslaught of Wall Street pros hawking their wares.

Google, being the best at what they do, felt that their staff deserved the best that the money management industry had to offer. In turn they brought in Nobel Laureate and Stanford University sage William Sharpe, Princeton economics professor and former dean of the Yale School  of Management’s Burton Malkiel, and revolutionary Vanguard founder and white-hat “Saint Jack”, more commonly known as John Bogle.

What did these world-renowned financial minds have to say? A simple but hard to accept truth – active money management doesn’t work. Instead, put your money into low-cost, diversified index funds and get back to the real business of life and to building Google into a world-class company. Over time and after fees and taxes, you will end up with more money and a better life.

Yes, it is true. Since 2002 S&P has been measuring the performance of active managers against their passive counterparts and has reported that over a five-year period, nine out of ten actively managed equity funds underperformed their corresponding passive indexes. Add to this travesty management fees, taxes from churn and marketing expenses, and the result is that over a 30 year period an investor can see as much as 40% of their portfolio growth evaporate. Paying for nothing is one thing, but paying for this abuse is what Google might call evil.

I know the truth, that passive investing after fees and taxes beats active money management, is hard to accept. You’re young, you’ve grown up hearing the tales of tech stocks going through the roof and are anxious to leverage your intelligence and abilities to outpace the averages. But take the advice freely offered from Bill, Burt and John. Do yourself a favor and read their books. You know how to code. These guys know how to invest.

And don’t expect the folks from Goldman Sachs, Morgan Stanley, or JPMorgan Chase to understand this truth. As John Bogle once said, “It is amazing how difficult it is for a man to understand something when he is paid a small fortune to not understand it.” If you want to protect your wealth, you’re going to have to search out this information yourself, listen to more independent minds, and be tutored by academic objectivity.

It took courage to put your career behind a contrarian concept. Don’t stop now. Have the courage to take another uncommon path. Learn the facts. Reject the active money management pitch. Diversify across low cost index funds and stay the course. If you do so, you will have more than an IPO to celebrate.

Sincerely,

Steve Beck

Vanguard Group has become the world’s largest fund company, with more than $1.7 trillion under management. Founder John Bogle discovered that indexing markets outperformed active managers after fees, and the firm has become a champion for low-cost investment products.

Now there’s another formidable player in this penny-a-point game.

Charles Schwab Corp. SCHW +0.29%  has aggressively entered the exchange-traded fund market with products that compete with both Vanguard and BlackRock Inc.’sBLK -0.10%  iShares lineup.

Schwab has ETFs covering all of the major asset classes, including Schwab U.S. Broad Market ETF SCHB +0.15%   to compete with Vanguard Total Stock Market ETFVTI +0.16% .

Schwab’s four bond ETFs include Schwab US Aggregate Bond ETF SCHZ -0.04% , which competes with Vanguard Total Bond Market ETF BND -0.01%   and iShares Barclays Aggregate Bond Fund AGG +0.02% . It also offers emerging markets and foreign developed-country ETFs, such as Schwab Emerging Markets Equity ETF SCHE +0.71%  that competes with Vanguard MSCI Emerging Markets ETFVWO +0.64%   and iShares Inc. MSCI Emerging Markets Index Fund EEM +0.67% .

Rebel, rebel

But here’s the clincher: Schwab is pricing several of its domestic-stock ETFs lower than Vanguard.

What’s the deal? When other ETF sponsors are looking for niches like a double-leveraged short on gold, why would Schwab go after the biggest and most entrenched products? Sure, Schwab has tremendous reach with millions of investors, but anyone can buy any ETF at Schwab because they trade like stocks.

Charles Schwab started his firm around the same time as Bogle started Vanguard. Leveraging new regulation in the 1970’s, Schwab launched the first discount brokerage and drove down broker commissions.

Once a rebel, always a rebel. Since Schwab took back control of his namesake firm, it seems that he sees an opportunity to disrupt the retirement industry, particularly 401(k)s. ETFs will enable him to do so and most important, leave a positive legacy for Schwab.

For Schwab, ETFs are not “funds” but rather tools for building precisely allocated, sophisticated retirement portfolios more akin to how endowments and pensions invest. Unlike the mutual fund world, where one active manager is pitted against another like jockeys in a horse race, ETFs are tools for getting market exposure. Markets are the ingredients of successful diversification — the more you have, the better.

U.S. stocks and counterparts in other developed countries tend to move independently from each other. So allocating money to both markets creates instant diversification. Emerging markets also move to the beat of a different drummer. Bonds and real estate are further afield from stocks, so adding these markets provides excellent diversification. Every year, some market wins and others lose and no expert can predict the future. So own them all! ETFs enable an investor to do so.

With a proper mix of ETFs tracking many markets, it’s possible for any investor with any amount of savings to build a low-cost, diversified portfolio including shares of U.S. companies, stocks in foreign developed countries and emerging markets, U.S. government bonds, real estate, and commodities. This wasn’t possible just a few years ago.

Schwab’s plan is to become a dominant player the 401(k) market, leveraging its ETFs and its broad platform. Because new Department of Labor laws require fee disclosure, corporations are going to wake up and realize that they are allowing their employees to be ripped off on a grand scale by many traditional 401(k) plans.

Enter Schwab with low fee 401(k) plans using ETFs. This is going to be highly disruptive. Today’s 401(k) platforms only accommodate mutual funds and that’s why employers can’t offer low cost ETFs to employees. Schwab’s new “Index Advantage” retirement plan will leverage the new changes in fee disclosure laws, its ETF roster, and a new 401(k) platform that accommodates them.

In this way, Charles Schwab, like Bogle, will cement his legacy as an advocate for working Americans and an investment industry leader who helped keep billions of dollars in people’s pockets.

This fictitious character’s predicament is not much different from what many stock traders face. In love with the Wall Street fantasy of trouncing the markets through laser-like stock selection, such investors prefer to see themselves as a type of Warren Buffett — processing data with superhuman accuracy to distill the investment insight of the day.

Such investors have convinced themselves that their fantasy is in fact reality — that they can overcome a million I.Q. points, a throng of Ivy League MBAs, and software systems engineered by rocket scientists, and pick a needle of a winner out of a massive equity haystack.

Potholes on Wall Street

In his insightful “A Random Walk Down Wall Street,” Princeton University professor Burton Malkiel effectively argues for what economists call the efficient market hypothesis — that the price of equities reflect all the publicly traded information and thus are efficiently priced. In other words, there are so many intelligent and informed investors staring at both sides of the buy/sell ledger that it becomes a crap shoot to try to pick a stock’s direction based on your reading of the tea leaves.

Armed with the same information, struggling against market pros is daunting enough. However, traders aren’t armed with the same information. They have brought a knife to a gun battle.

The SEC is hotly pursing cases of rapid-fire trading, in which complex computer systems allow institutional groups to jump ahead of the average guy in an exchange’s “order book.”

Capable of anticipating that your trade is about to hit the system, these geniuses have found a way to front-run your activity, harvest a profit and get out in the blink of an eye. Such computerized trading now represents almost one-third of all daily exchange volume. To add injury to abuse, the SEC has discovered that these same rats earn rebates on their transactions from the exchanges even as regular investors pay fees to complete their trades.

Don’t believe that high frequency trading is Wall Street’s only advantage. In an effort to undo the efficient market hypothesis, Wall Street pros are always angling for bits of information the average guy can’t obtain. Competing against these traders is a fool’s errand. As the Las Vegas adage goes, “Look around the poker table; if you can’t spot the sucker, it’s you.”

So what is an investor to do? Quality ETFs provide an answer. Low in cost, highly diversified and tax efficient, these vehicles give the average investor more than a fighting chance to emerge from the fray a winner. With ETFs, investors own a bit of everything in proportion to their individual needs — in the next year, some of their holdings will rise and others will fall, but over time they will reap the rewards of participating in the free market’s productivity.

Smart investors own stocks from the U.S., through a fund such as Vanguard Total Stock Market ETF VTI -0.81%   and around the world through funds such as Vanguard MSCI European ETF VGK -2.29%   and Vanguard MSCI Pacific ETF VPL -0.85% .

In addition, they own bonds through Vanguard Total Bond Market ETF BND +0.19%  , and get commodities exposure through SPDR Gold Shares GLD -1.19% and iShares S&P Global Energy IXC -1.24% ,  and real estate exposure in SPDR Dow Jones REITRWR -0.07% .

These investors have the discipline to trim what is going up and buy what is going down. Guided by a plan as opposed to intuition, they bought stocks when the S&P 500 Index SPX -0.77%  crashed in 2009 and trimmed their bond holdings. Today, they’re adding to their bonds while trimming fast-rising stocks.

What does a fool believe? For the trader, it’s a fantasy of beating the pros. For those of us who prefer reality, using ETFs for low-cost indexing, asset allocation, and disciplined rebalancing is the game to play.

The Roller Coaster from Hell
When it comes to roller coasters, even the youngest children know they should remain buckled in their seat until the ride deposits them safely back on terra firma. Unfortunately, for investors, the stock market allows a panicked rider to hit the eject button midcourse in spite of the risk of being thrown headlong to an ignominious demise.

According to research by Drs. Joy and Layton Smith, professors of Finance at Coggin College, this is exactly what many investors in fact did. Gripped by fear from both the market collapse of 2009 and the Flash Crash of 2010, a majority of investors abandoned their portfolio plan in a “flight to quality”. The roller coaster drama of watching a life of hard work and disciplined savings be hewn in half in a few short and horrific months was, for most, too much to bear.

Like an ultimate fighter suffering an unbearable chokehold, investors “tapped out” in a “flight to quality” – selling their stocks in favor of treasury bonds. Investors no longer cared that bond yields produced less than the annual inflation rate. They wanted off the crazy train and were in desperate need of security.

The Power of a Plan
In the late nineteen-sixties, Walter Michel, a Stanford professor of psychology performed the now historic Bing studies more commonly known as the marshmallow test. In this study, researches sat four year-old children at a table in a private room, marshmallow temptingly placed in front of them on a solitary plate. The kids where further told that the instructor must leave the room but would be back shortly. If they wanted, they could eat the marshmallow at any time, but if they waited for the instructor’s return, they would receive a second marshmallow as a reward.

On average, children lasted about three minutes before caving into desire and consuming the treat. However, thirty percent of the children lasted the entire fifteen-minute wait, receiving the reward of a double portion.

It is no surprise that after tracking of these children into adult life, those with the ability to delay gratification had greater success across many areas of life. One of the remarkable insights of the Bing studies, however, was in how children successfully in delaying gratification – something us shot delayers need help with. The high delayers approached the stress of the marshmallow temptation quite different from the majority – via something researchers called strategic allocation of attention. Instead of sitting there and getting obsessed with the marshmallow or “hot stimulus”, the children distracted themselves with other activities, like playing hide-and-seek underneath the desk, singing songs or moving about the room. Their desire wasn’t defeated – it was intentionally ignored via a distraction plan.

A simple analysis of the past three years demonstrates how this same skill worked for some investors. Take for instance a simple $1M portfolio of 50% stocks via the SPDR S&P 500 ETF, SPY, and 50% bonds via the Vanguard Total Bond Market ETF, BND. If an investor had simply made those purchases on August 1 of 2008, turned off every news source and spent the last three years gardening or playing with the grandkids, as of March 9, 2012 that investor’s account would be a robust $1,213,140 with a return of 21.32%. Not too shabby a three-year return for the worst market in modern history.

Now what happens if that same investor added the basic discipline of rebalancing according to the pre-established portfolio plan? The MarketRiders analytics engine reveals that such an investor would have been alerted to rebalance eight times over those three years. The results of the rebalancing are that the investor enjoyed account growth to $1,260,598, or a return of 26.07% – a 4.75% outperformance to the unbalanced equivalent.

Founder of the Vanguard Group and white hat, John Bogle, wrote, “Stay the course. No matter what happens, stick to your program. I’ve said ‘stay the course’ a thousand times, and I meant it every time. It is the most important single piece of investment wisdom I can give to you.”

As much as investors believe that they can anticipate the downturns and time the market, research repeatedly debunks this myth. This three-year anniversary of the downturn has once again illustrated that bailing out of even the simplest of portfolio plans is an easy way to torpedo your investment program. Yes, this turbulent journey sure felt hopeless at times, but steadfast investors understood the dictum – this too shall pass. Like the kids with the marshmallows, staying focused on the plan helped such investors resist the temptation to react, and in the end, they move a little closer to their reward of a double portion.

A recent Yankelovich survey found that four in 10 investors believe investment companies are unfair — joining the ranks of credit card companies, CEOs, the federal government and of course, lawyers.

Goldman isn’t the only offender. There is no industry more ridden with conflicts of interest and misaligned incentives than investment management. David Swensen, who deftly oversees Yale University’s endowment writes: “Relationships with external investment managers provide a fertile breeding ground for conflicts of interests.”

He noted that while investors seek high risk-adjusted returns, investment advisers “pursue substantial, stable flows of fee income.”
 
Agent secrets
So if you have accumulated a few bucks and want to leave your investing plans to an expert, your conundrum is: How do I delegate in an industry full of charlatans? How do I protect myself from being someone’s muppet?

The answer comes from studying the practices of elite endowments, pensions, and wealthy families.

Unlike everyday investors who blindly trust “experts,” smart institutions have identified and actively manage “agency risk.” An agent is anyone who you trust to handle, your money.

Hiring an agent creates risk — big risk — because agents will not always act in your best interest. If you own your business, you have no agents, and no agency risk. You are in control. Conversely, agency risk must be managed.

Do you own shares of a public company? Its directors and management are your agents, operating the business on your behalf. Managers want to keep their jobs and receive greater compensation. Directors enjoy their board fees and the prestige. Management and directors often develop an entire dynamic keeping one another happy and spending your (shareholder) money in ways that you wouldn’t. Activist hedge funds like Starboard Value and Opportunity Fund seek out companies where profits are being squandered through such misalignments and demand changes to better serve shareholders.

Own a mutual fund? That’s another layer of agents. Fund managers are hired to outperform an index. To do this, usually requires concentrating a portfolio around fewer stocks. But mutual fund managers learn early that if one of their bets is wrong, they can lose their jobs. To survive, managers begin “closet indexing,” owning many stocks, which means they’ll rarely justify their fees, but they won’t get fired either. That’s not in your best interest.

Have a wealth manager? Now you have a third layer of agency risk to pick the fund managers who pick the securities. Large firms like Goldman get payments from fund firms for “distribution” — channeling client (muppet) money into their funds. Worse yet, firms sell clients their own proprietary funds and make money from both the fund and from putting you into it.

With three layers of agents, everyone has their hand in your pocket. That’s what defines a muppet!

MarketRiders is designed to nearly eliminate agency risk. We make being a do-it-yourselfer really easy and fast, like painting by numbers — we promise! But if you are not a do-it-yourselfer, here are three ways to reduce agency risk:

1. RIA vs. broker: Do you know the difference between a registered investment adviser (RIA) and a broker? They are as distinct as chiropractors are to orthopedic surgeons.

2. Index funds vs. actively managed funds: Most investors don’t know the difference between an index fund and an actively managed fund. If you are one of them, do some homework. With an index fund or exchange-traded fund, you can save on fees and replace fund managers with computers that buy every stock in a particular market. Performance? The statistics are indisputable — owning active funds is an expensive loser’s game. That’s one reason why Vanguard Group, which created index funds, is now the largest money manager in the world with $1.75 trillion.

3. Clearing brokers: Where your money is located is a critical decision. Make sure that your money is held by what is called a “clearing broker,” like Charles Schwab or Fidelity Investments — not your local independent broker dealer. Clearing brokers are much more regulated and plugged into what is called the Depository Trust and Clearing Corporation (DTC). This dramatically lowers the risk of fraud and helps insure that no one but you can move money out of your account.

Enjoy watching the Muppets; don’t become one. Having your own account at well-known firms such as Schwab and Fidelity, with an independent adviser (not a broker) buying you a portfolio of index funds, means you’re investing with fewer strings attached.

Inflation could derail boomers’ retirement

Inflation poses a threat to stocks and bonds, and paltry returns could be washed out altogether as baby boomers retire, according to Robert Arnott, Pimco fund manager and chairman of Research Affiliates, who has ways to hedge against such events. Laura Mandaro reports.

Yet because of demography, taxes and debt, their nest egg may not get the job done.

Demographics, the first bandit, is robbing investors of previously anticipated market returns.

The baby boom generation is heading into retirement with the momentum of a massive locomotive. Every day more than 10,000 Americans reach the age of 65. This will continue happening every day through 2030, forming a potent wave of retirees seeking retirement income.

Headwinds of change

While retirees sell stocks in favor of bonds in search of predictable income and greater security, a persistent headwind will hit the stock market. Many doomsday prognosticators believe this downward pressure will result in calamity, but it is more likely that the countervailing force of young, up-and-coming foreign investors will steady the ship. Still, the glory days of 10% annual portfolio returns year after year are likely behind us for the foreseeable future.

If demographic shifts are not intimidating enough, retirees face a second robber — higher taxes. The Bush era tax cuts are set to expire at the end of 2012, and as a result many Americans will see a 3% to 5% increase in their nominal tax rate along with additional increases to fund Medicare and other special programs.

And just when many retirees are scooping up dividend-producing stocks, the dividend tax rate is set to go from its current, motivating 15% to a taxpayer’s ordinary income tax bracket — for some as high as 39.6%.

Plus, there is the invisible tax of inflation. The Bureau of Labor Statistics shows annual inflation to be around 3%; critics claim it is underreported and is significantly higher when measured by the older, 1980 standard.

Finally, there is the U.S. debt. This bandit comes out of hiding via the Federal Reserve’s artificially low interest rate program. In an effort to stimulate the economy back to health and slowly inflate out of our debt debacle, this low interest rate program has left today’s retiree with his pockets empty and hands held high. While the traditional government bond portfolio coughs up a meager 2%, inflation and taxes steal back much more.

See risk differently

To confront the bandits and win, you need a new and more creative approach to income generation.

Simply piling into dividend stocks or running or entrusting all your retirement money to one insurance company via an annuity does not provide the diversification many smart investor requires. Shrewd income portfolios must be highly diversified across asset classes as well as within them.

Additionally, the portfolio must be low-cost and as transparent as possible. There is no reason to cough up a few percentage points in fees when a few percentage points may make the difference between success and failure. This portfolio also needs to be tax-efficient and have an inflation hedge.

For those MarketRider’s investors willing to customize a higher octane income portfolio via the Let Me Build It functionality, here are a few strategies to consider:

1. Emerging market debt: Emerging nations pay 5% to 7% in bond yields, substantially higher than comparable Treasurys. When some hear emerging economies, they immediately think high risk. Emerging economies are ostensibly going to be the growth engine for the world’s economy in the next 10- to 20 years. Additionally, they have far less debt relative to the size of their economies than do developed nations.

Fairly priced, transparent and diversified exchange-traded funds are easy to find. Check Powershares Emerging Markets Sovereign Debt ETF (NAR:PCY)   or iShares JP Morgan USD Emerging Markets Bond (NAR:EMB) . Last year, each of these low cost ETFs produced more than 6% in annualized yield, were highly diversified across dozens of emerging market economies, and had excellent volume.

2. High-yield corporate debt: After learning more about today’s quality high-yield bond ETFs, you too may decide to add a little “junk” to your portfolio. SPDR Barclays Capital High Yield Bond ETF (NAR:JNK)   produced a 7.5% yield last year with massive diversification across a broad swath of industries. Surely, this is no Treasury bond vehicle, so buckle your seat belt and mix this with careful forethought. Adding a little JNK provides some seasoning to your income portfolio and is an additional defense against the bandits.

3. Large-cap dividend ETFs: Dividend stocks are the darlings of the day. With dividends returning more than Treasurys, and the underlying stock ownership providing an inflation hedge, many are getting on the bandwagon. Instead of taking on the unnecessary risk of buying a handful of dividend-producing stocks, some great ETFs help you get diversification and cost structure for a winning portfolio. Check out Vanguard Dividend Appreciation ETF (NAR:VIG)   or iShares Dow Jones Select Dividend Index (NAR:DVY) , which each boast more than $10 billion in assets.

4. REITs: By blending SPDR Dow Jones REIT (NAR:RWR)  with SPDR Dow Jones International Real Estate ETF (NAR:RWX) , you can top U.S. government bond yields and achieve principal growth. Although you’ve moved outside the realm of traditional fixed-income investing, REITs provide another good source of diversity and yield.

5. MLPs: Master Limited Partnerships can be powerful portfolio tools. The top MLPs run the nation’s oil and gas pipelines and, as limited partnerships, require the distribution of profits. Accordingly, MLP investors historically have received between 6% and 10% in pass-through income with some attractive tax advantages if you don’t mind the hassle of having to process K1 tax forms at the end of each year.

Previously only for sophisticated investors, MLPs are now available to the masses through exchange-traded notes such as JP Morgan’s Alerian MLP Index ETN (NAR:AMJ) . This portfolio combines a diversified blend of high-quality MLPs, but earnings are reported as ordinary income. So you don’t deal with a K1, but you also miss the tax benefit.

The problem with AMJ is that you do not own the underlying partnership, but a note or loan to that partnership, so you also assume credit risk. Although clearly not for everyone, this ETN, with a tendency to move independent of market swings, may be worth closer consideration.

The new Pimco Total Return ETF TRXT -0.23% is an outlaw in ETF-ville, because it represents the opposite of everything the townsfolk set out to do when ETFs were created.

ETFs freed investors from high mutual-fund fees, allowing allocations to about any type of asset class for a fraction of the cost. Most ETF investors have a point of view about investing that goes like this: “Let’s stop trying to beat the market. Let’s just ride the market, pay really low fees, get what the market delivers and drink to that!”

And while there are 1,300 ETFs and $1.1 trillion invested, most of these are irrelevant. The top 50 ETFs comprise well over 70% of money invested in ETFs and most remain “pure” in their original intent: built to be managed by computers to mimic a popular, widely understood index for less than a competitive mutual fund.

But now the mutual funds have morphed into a different kind of villain, ready to terrorize the townsfolk who like their funds cheap and their managers, well, high powered computers. Pimco’s ETF is expensive — 0.55% after a fee-waiver — relative to other bond ETFs such as Vanguard Total Bond Market BND -0.10% , at 0.11%, because it is “actively” managed.

Actively ETFs comprise less than 1% of the market today. Will Pimco’s arrival drive this new form of ETF “bastardization?”

For the newbie in ETF-land, understanding ETFs is about to get even more confusing. So here’s a little history:

The Good. In 1993, State Street Bank launched SPDR S&P 500 ETF Trust SPY +0.06%, the first ETF on the S&P 500 Index SPX +0.36% , known as SPDRs or “Spiders.”

Then a new company, iShares, discovered this territory and released indexes of all major countries in 1996. From EWC (Canada) to EWJ (Japan) to EWK (Belgium), investors could now cheaply invest in entire nations. Not to be outdone, State Street released indexes on all major U.S. sectors. Later, Vanguard, which invented the whole concept of index funds, woke up and released ETFs around their major index funds. And for most of us, the town was good. We had every index we needed to build and manage a great, diversified, inexpensive portfolio.

The Bad. But just when the townsfolk were cheering the arrival of every kind of useful ETFs, the ETF industry drifted from its sound mooring.

The SEC approved a redefinition of the term “index” in 2003. Before then, ETFs were limited to holding baskets of stocks that tracked broad market indices like the S&P 500. After 2003, the SEC allowed anyone to form newfangled “indices” based upon any rules they made up. This changed the definition of an index and allowed the Wall Street crowd to run wild, creating the latest, greatest “index” de jour and cluttering the universe of good ETFs.

New indexes began popping up, polluting the original purity of ETFs as suitable building blocks for asset allocation. A “sin” index of casinos, producers of beer and malt liquors, distillers, vintners, as well as cigarette manufacturers was created and later closed. Today, you can invent any “index” you want, and create an ETF based on it.

The Ugly. When leveraged ETFs got released, things got very risky.

These leveraged products would sometimes severely deviate from their underlying index over the long haul. And leverage is dangerous. For example, Direxion Daily Financial Bear 3X Shares FAZ -0.25%   plunged 95%, earning it the ignominious title of worst performing ETF in 2009. And ETFs were offered that hold futures contracts and options, mostly to achieve commodity exposure. Futures-based funds can fail to track their target index and are vulnerable to all kinds of technical problems.

Law and order

When trying to make sense of the world of ETFs use these five simple principles to guide you to the good and away from the bad and ugly:

Holdings: Make sure your ETF holds only stocks or bonds. If you see options or futures contracts, options or leverage — run!

Fees: With few exceptions, don’t pay more than 0.5% in fund fees, and for a portfolio of ETFs the weighted average fee for the entire portfolio should be under 0.25%.

Billion: . Quality ETFs have more than $1 billion in net assets and substantial daily trading volume. This affords sufficient volume and liquidity so that the bid/ask spreads are narrow.

Turnover: Except with bond portfolios, which have expiring securities, make sure the stocks have annualized turnover of less than 20%. This means that there are no fancy algorithms trading in and out of positions.

For most of us, the new active ETFs from Pimco and others will either be bad or ugly. They surely will not be good as they will continue to confuse and dilute the purity of one of the greatest financial innovations ever created. Here’s hoping the new bandits are unable to find a willing market, leave town for good and stop peddling their expensive mutual funds dressed up as ETFs.