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       Investor's Insight - October 31, 2006           
          "A Digest of Investment Opinion From the 
             World's Leading Financial Advisers"


by Scott Burns

Does it make sense to become an ETF (exchange-traded fund) 

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 

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 

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).



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