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Many financial innovations make it easier to invest successfully. In other cases, though, new products only serve to separate you from your money.

Exchange-traded funds (ETFs) have evolved from a tiny offshoot of the mutual fund market to a $1 trillion industry of their own. Once limited to just a few broad-market funds, the wide range of ETFs now available allow you to slice and dice the investing world however you want.

As you'd expect in any growing market, however, some ETFs make better investments than others. As the number of ETFs continues to grow, it seems as though new fund offerings are hitting a point of diminishing returns, not providing enough additional value to justify their cost.

Nesting ETFs
Take the One Fund (NYSE: ONEF  ) , for instance. This brand new offering uses an "ETF of ETFs" approach, investing among already available ETFs. Seeking to offer investors a one-stop shop for equities around the world, the One Fund's portfolio currently consists of five ETFs that span more or less every stock sub-asset class.

In particular, the fund uses two readily available ETFs to implement a simple asset allocation strategy. Currently, the One Fund has 70% of its assets in two U.S. stock ETFs, Vanguard MSCI US Prime Market (NYSE: VV  ) and Vanguard MSCI US Small Cap 1750 (NYSE: VB  ) . On the international side, a 20% allocation to Vanguard MSCI EAFE (NYSE: VEA  ) and 5% in Vanguard Emerging Markets (NYSE: VWO  ) gives you large-cap exposure to developed and emerging markets. A 5% dollop of iShares MSCI EAFE Small Cap (NYSE: SCZ  ) adds some small-cap spice to the foreign side of the portfolio.

In exchange for providing this service of aggregating five low-cost ETFs into a single package, however, the One Fund turns into a fairly costly investment, at least as ETFs go. Predictably, the Vanguard and iShares offerings have relatively low expense ratios, amounting to about 0.16% for the mix of ETFs that One Fund owns. But One Fund adds its own management fee of 0.35% to choose those ETFs -- more than tripling the net cost of establishing the portfolio.

Do it yourself
Now, I'll admit that there's some value in providing a single investment that encapsulates multiple asset classes. Moreover, the One Fund purports to be actively managed, so presumably, the investments the fund makes may shift over time.

But that doesn't justify the One Fund's added costs. Thanks to Vanguard's recent cost-cutting initiative, you can open a brokerage account there and get free access to all four of the Vanguard ETFs the One Fund currently owns, all of which would make sound components of your overall portfolio. Moreover, you'd have access to dozens of other ETFs that Vanguard offers. With a wider selection of available ETFs, you'll find it much easier to create your own custom-made mix of ETFs, drawing from all of Vanguard's offerings to put together a portfolio allocation that's uniquely tailored to your own financial goals and needs.

Keeping your holdings in separate funds also gives you some tax-related benefits that a single fund doesn't offer. Since you have control over all the component ETFs in your self-made portfolio, you can time purchases and sales among various ETFs to minimize capital gains and harvest tax losses.

With all those benefits, saving the 0.35% that One Fund charges is just icing on the cake.

Simple is smart
This won't be the last time that a new financial product tacks on extra charges for something you could do yourself. But every time someone shows you what they believe is the next big thing, ask yourself: Is there anything here that you can't do better and more cheaply with tools you already have? If the answer is no, you're probably better off sticking with the tried-and-true investment vehicles you've used for years.

Last week's 1,000-point mini-crash showed us up close and personal what financial innovation can do. Find out from the Fool's team of experts exactly what the heck happened.

Fool contributor Dan Caplinger knows there's no one ETF for anyone. He doesn't own shares of the funds mentioned in this article. The Fool owns shares of Vanguard Emerging Markets Stock ETF. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy was our single best financial innovation.

Read/Post Comments (1) | Recommend This Article (11)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 23, 2011, at 11:43 AM, jkbennett wrote:

    Diversification is really a lot trickier than people think. I agree that One Fund is kind of easy to mimic and doesn't really look very diversified or at least disciplined in selection anyway. But it is a kind of a step in the right direction.

    But, I do think as there is one complex and shifting investing target for the global masses wanting "diversification for the long term", whatever that is, is poorly defined still and left to individuals. This doesn't make sense as it is actually a harder analysis of more data than just picking stocks.

    I think there is a way to mathematically manage allocations using algorithms and ETFs of ETFs and a few investment vehicles. I wish I find and buy a few of those and spread some money across them.


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