Publication: Investor's Notebook
PRACTICAL ETF INVESTING | |
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Investor's Insight - October 31, 2006
"A Digest of Investment Opinion From the
World's Leading Financial Advisers"
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PRACTICAL ETF INVESTING: THE ONLINE CALCULATOR
by Scott Burns
Does it make sense to become an ETF (exchange-traded fund)
investor?
I think so. The smaller the commission cost of buying and
selling -- measured as a percent of assets invested -- the
more attractive ETF investing is.
The surprise is that it makes sense for relatively small
portfolios.
How small?
Let's try an extreme example. You're a new investor. You've
just put together your first $2,500. Jimmy Buffett, not
Warren Buffett, is your soul mate. So you want to create a
Margarita Portfolio with three exchange-traded funds -- a
U.S. total market equity fund, a broad international equity
fund and a fund that invests in a Treasury Inflation-Prot-
ected bond index.
How much will it cost?
Answer: Sorry, too much.
While Fidelity Investments charges commission rates as low
as $8 for those who have $25,000 in assets and make 120
trades a year, its standard rate is $19.95. Other firms are
in that range as well. If you added to your account and
rebalanced only once a year, the commission cost would be
nearly $60, and the annual expense would be 2.39 percent of
your investment -- plus the average expense ratio of the
underlying funds.
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That makes ETFs a non-starter for beginning investors.
As I have pointed out in other columns, beginning investors
are better off selecting a single diversified fund and
growing their nest egg in that fund until they have enough
that the commission expenses of ETF investing are small.
Fidelity Four in One index fund comes to mind, as does
Vanguard Balanced index.
Fortunately, you can estimate commission expenses in ad-
vance. So it's easy to know when you will be a cost-
efficient ETF investor. To do some exploring, I built an
online calculator.
Type in the value of your portfolio, the number of times
you intend to rebalance or add to the portfolio in a year,
the annual account fee (if any), and your commission rate.
Presto! The ETF Portfolio Cost Calculator will display the
cost per year for portfolios of one to eight funds in total
dollars and as a percentage of the total portfolio.
Using the calculator, I made some interesting discoveries.
You can, too.
A surprisingly small investor can beat the cost of the
average managed fund. According to Morningstar, for in-
stance, the average managed moderate allocation (balanced),
world allocation or lifecycle fund has annual expenses of
about 1.40 percent. The ETFs used in the Margarita Portfolio
have annual expenses that run from 0.07 percent (Vanguard
Total Market index, ticker: VTI) to 0.36 percent (iShares
EFA index, ticker: EFA). They average about 0.21 percent.
So if your commission costs are less than 1.19 percent a
year, you may do better with a self-managed ETF portfolio
than with a typical managed fund.
How big does your portfolio need to be? Try anything over
$5,000.
Yes, you read that right: $5,000. Almost anyone can be an
ETF portfolio investor.
You can do a lot with a $50,000 portfolio. The major broker-
age firms penalize brokers for dealing with "small" acc-
ounts. They routinely seek accounts 10 times larger.
But you'll have low costs and great flexibility if you
happen to have $50,000.
At that asset level, for instance, the Fidelity commission
schedule gets chopped to $10.95 a trade. You can rebalance
a portfolio of three ETFs four times a year, and your total
commission cost will be only $131. That's 0.26 percent of
assets a year.
Add the expenses of the underlying funds, and your total
expenses are still under 0.5 percent a year.
Indeed, with $50,000 you could have a portfolio of eight
ETFs that you rebalanced four times a year, and your total
commission expenses would still be only 0.70 percent a
year. If the underlying ETF expenses averaged 0.30 percent,
your total portfolio cost will be less than the 1.03 per-
cent average annual expense ratio of the 71 largest moderate
allocation mutual funds -- those with assets of at least
$10 billion under management.
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Limit your portfolio to four or five ETF choices, and your
total expenses, including the expenses of the underlying
funds, would likely be less than 60 basis points (0.60 per-
cent). Only a handful of giant funds can make that claim --
funds such as Fidelity Puritan (0.62 percent) or Vanguard
Asset Allocation (0.38 percent). Several funds in the Amer-
ican Funds group can make that claim -- but they all have
up-front commissions.
For large portfolios, brokerage commissions are a virtually
trivial expense. Parsimony has its limits. With $250,000 in
assets you can have a portfolio of five or six ETFs, re-
balance it four times a year, and your expenses will be
about a tenth of 1 percent. You could, in other words, man-
age a nicely diversified portfolio for a total expense of
less than 40 basis points a year. That gives your index
portfolio a full 1 percentage point "head start" over the
cost of the average managed fund.
As a practical matter, it won't be necessary to add or sub-
tract from every holding when you add or rebalance, so ex-
penses are likely to be somewhat lower.
This is a major opportunity for individual investors.
Want to explore this for yourself? Try my online calculator,
under "calculators" at www.scottburns.com
You can discuss this issue or any other topic in the new
Investor's Insight forum. Check it out here...
Investor's Insight Forum
(Investor's Insight reflects the opinions of experts. It does
not recommend any specific investments, and no endorsement is
implied or should be inferred. For more information, contact
the individual firms cited).
COPYRIGHT 2006 UNIVERSAL PRESS SYNDICATE
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