Rebalancing is a key to lower risk and higher returns because it forces the discipline and takes the emotionalism out of “buy low and sell high.” The illustration below shows how a simple portfolio that has a target allocation of 50% bonds and 50% stocks gets rebalanced as the allocations move away from their targets.

As you read stories about victims of the Madoff fraud, aren’t you glad that you weren’t one of them? Why are you so sure that it will never happen to you? How do you know its not happening to you now?

In academic financial research, there’s a concept called “agency risk.” Agency risk occurs when someone who is acting as your “agent” has a set of interests that conflict with yours. In investing, agency risk is rampant because one party can often gain from an action that will cause a loss to the investor without the investor even knowing it! Bernie Madoff was an agent of the investors who hired him to manage their money and he was crooked for years until his scheme ended. But investors face plenty of legal, yet sometimes equally dangerous forms of agency risk. It is important to understand them and find ways to mitigate these risks.

My title sounds a little stupid, right? Wrong. Many of our MarketRiders members and investors new to ETFs have been worried about having ETFs with the name “Lehman” in their portfolios, particularly the prolific Lehman 1-3 Year Treasure Bond Funds (SHY) or the Lehman TIPs Bond Fund (TIP). Some investors are confused why these ETFs haven’t gone to $0. In fact, some of them are doing quite well this year.

For the new ETF investor, it’s important to understand that ETFs are created based upon a pre-defined index. An index is defined and maintained by an organization – some of which are more credible than others. For example, Standard and Poors has many equity indices like the S&P 500. The Russell 1000, 2000 and 3000 indexes were developed to track a wider breadth of US stocks and were developed by the Frank Russell Company. Morgan Stanley (MS) runs an enormous indexing businesses.

The famous professors at Yale have proven that asset allocation accounts for 90% of a portfolio’s return and that stock picking and market timing account for less than 10%.   So what a great time to look at how different asset allocations are faring in this market! 

In 2008 it turns out that asset allocation decisions have everything to do with a portfolio performance. 

 From May 2000 through May 2008, the S&P SmallCap index (IJR) is up over 50% from its competitive index the Russell 2000 (IWM).  Both indices, IJR (S&P 600 SmallCap Index) and IWM (Russell 2000 Index) purport to give an investor exposure to small cap stocks in the US stock market.  The average market caps are similar and many of the same companies exist in each index.  But why does IJR do so much better than IWM?

The S&P 600 SmallCap Index Beats the Russell 2000 by 52% over 7 Years*

Our firm has developed an ETF/ETN database with our own classifications. This database powers the software on our website (www.marketriders.com) that allows individual investors to build a well diversified portfolio using ETFs. When we update our database we develop some unique insights regarding the growth and current state of the ETF market. We share some of these perspectives with interested Seeking Alpha readers. One caveat: a few of the newer ETFs are not included, but we have included nearly 700 ETFs that today account for at least 99.5 % of all funds invested in US ETFs.

First, here is a macro view of US ETFs from a net asset value [NAV] perspective. With over $600 billion invested in ETFs, 25% is invested in the top 3 ETFs (SPY – 14%, EFA – 7%, and EEM – 4%). Forget the 80/20 rule here. In fact, 50% of all capital invested in ETFs is in the top 16 ETFs, or the top 2%. Only 100 out of 693 ETFs have an NAV of over $1 billion and only 55 ETFs between $500m and $1 billion. In fact, half of all ETFs have a NAV under $75 million. Lower NAVs imply less volume and liquidity. Thus, all of the discussions on SeekingAlpha that caution investors about the bid/ask spread risk of buying ETFs are justified when so many have such limited liquidity and volume.

I've read David Swensen, William Bernstein, John Bogle, Larry Swedroe and others and I've "drunk the kool-aid." I'm now a die-hard asset allocator. If you are like me, you've determined an asset allocation that's comfortable for you and invested in index funds or ETFs to execute that allocation.

But if you're truly committed to a strategy of asset allocation, this market brings you to the ultimate moment of truth: Are you willing to rebalance? Markets do ebb and flow over time, and your allocations will shift from target percentages. Rebalancing means taking the counter intuitive action of selling shares of markets that are performing well and buying more shares of ones that have been lagging. The process of rebalancing means that you buy and sell to realign with your target percentages.

If you have exposure to an asset class, it's important to maintain that exposure and not try to become a fortune-teller, attempting to figure out when to "get in or get out." The famous professors at Yale have proven that asset allocation accounts for 90% of a portfolio's return and that stock picking and market timing account for less than 10%. Many studies also show that large up moves in the market happen quick and just a few days over many years, account for most of the gains that markets achieve. So trying to time a market – particularly in these volatile times – is a fool's errand.

But there is something you can do during a downtown to pick up a little extra return besides shorting stocks. ETFs are unique vehicles for helping with the tax bill in large market downturns such as the one we are experiencing. Did you know that you can sell an ETF for a loss and buy a similar one that gives you substantially the same exposure, and take a tax deduction?

The Wall Street Journal reported on December 3, 2007 (Section R1) some interesting information in an article titled "Winning Funds Share Traits, But the Trick Is Finding Them." The article attempts to help mutual fund investors determine what characteristics a mutual fund had before it began an 8 year streak of beating the S&P.

We started by identifying a group of mutual funds with the longest winning streak against a well-known measure -- eight straight years of beating the Standard & Poor's 500-stock index. Only 30 U.S. stock funds made the cut, out of 1,935 eligible funds tracked by Morningstar Inc. Then we asked Morningstar to crunch the funds' data from 1998, as the streaks were set to begin....Along the way, we also noticed ...five of the seven focused on natural resources, such as oil, that were beaten down in 1998 but have boomed since. The lesson? Be willing to invest in categories that have been out of favor, since they may be due for a resurgence.