Both family of funds have relatively low expense ratios, with Vanguard being the lowest. Except for two micro cap ETFs, we eliminated any ETFs that had an expense ratio higher than 50 basis points (0.50%). We also built a worksheet to help allocate funds among the various asset classes. You can see the results of this research and the ETF worksheet in a Google spreadsheet or the original Excel spreadsheet.

Here is a portfolio made up of exchange traded funds.  This portfolio has no bond or fixed income component.  It provides both relatively high return and moderate volatility making it appropriate for the long term.

The portfolio currently has an asset allocation of:  45% domestic stocks, 35% international stocks, and 20% REITs.  The portfolio was rebalanced earlier this year to include greater international exposure. 

This portfolio includes 13 ETFs and one index fund.  The ETFs and one index fund are based on broad market indices.  Vanguard ETFs predominate because they offer the lowest expense ratios and they closely track the market indices they track.

An ETF-based portfolio does not have include this many different subclasses of assets. A total of three three to five ETFs is all that is needed to get the benefit of diversification across different asset classes. Here are two examples:

• A 3-ETF Portfolio – 50% Vanguard Total Stock Market ETF (VTI) ; 35% iShares MSCI EAFE Index Fund (EFA); and 15% Vanguard REIT ETF (VNQ)
• A 5-ETF Portfolio – 30% Vanguard 500 Index (VFINX ) or Vanguard Large-Cap ETF (VV) ; 20%Vanguard Small Cap Value (VBR); 20% iShares MSCI EAFE Index Fund (EFA); 15% Vanguard Emerging Markets ETF (VWO); and 15% Vanguard REIT ETF (VNQ)

Note:  VFINX is an index mutual fund.  However, it can be purchased through an on-line broker.

However, he goes on to comment: ETFs, simply put, are index funds that can be traded in the financial markets. In fairness, if they are not traded, they can often be the equal of the classic index funds.

ETFs that represent broad market indices offer several advantages to the small investor. First, they can be traded like stocks, there is no minimum purchase. When the corresponding index fund is purchased outside of an IRA, there is usually a minimum ($3,000 for many of the Vanguard funds).  Second, the ETFs typically have a slightly lower expense ratio. For example, the Vanguard Total Stock Market Index Fund Investor Shares (VTSMX) is a mutual fund with an expense ratio of 0.19%. The Vanguard Total Stock Market ETF (VTI) is the corresponding exchange traded fund and has an expense ratio of 0.07%. For a $10,000 investment, the 0.12% difference in expenses would result in $12 in buying the ETF.  This enough to offset the commission, assuming it is purchased through a discount broker.

Learn more about index fund investing at the Bogle Financial Markets Research Center and The Bogle eBlog.

An index fund is a mutual fund consisting of stocks that correspond with a market index. An ETF is a stock certificate reflecting underlying assets that correspond with a market index. Index funds are bought and sold like mutual funds, i.e., at the end of each trading day. ETFs trade continuously traded throughout the business day on the major exchanges like other stocks.

Index funds can be purchased through some of the large family of funds. Vanguard and Fidelity offer a wide range of low cost index funds. You also can purchase index funds through a broker, but this usually results in a brokerage fee. Since ETFs are traded as stocks, they can be purchased through any broker. While there is a brokerage fee for purchasing ETFs, there is no minimum dollar amount or number of shares. Since they are mutual funds, index funds require some minimum purchase. For smaller portfolios, it may be easier to diversify using ETFs.

What goes into a portfolio of ETFs or index funds? There are many different views on this but, typically, the portfolio is divided into three or more asset classes. This might include domestic stocks (30-50%), international stocks (20-40%), REITs (10-20%), and bonds (20-40%). A simple portfolio might include a broad market index such as the Vanguard Total Stock Market Index (40%), a broad international stock index such as the Morgan Stanley MSCI EAFE (40%), and a bond index such as the Lehman U.S. Aggregate index (20%). A portfolio of just these three indices provides decent diversification.

Depending on the amount of money to be invested, the major asset classes can be further subdivided. For example, the 40% in domestic stocks about be further divided as follows: total market index (10%), large cap blend (10%), mid cap blend (10%), and small cap blend (10%). (A blend includes both growth and value stocks). The domestic equities can be skewed toward a value style by selecting value funds instead of blended funds for each of the various market caps, or each market cap could be split between value and blended indices. Similarly, the international component can be subdivided among European, Pacific, and emerging or developing markets.

Including a bond component such as the Lehman U.S. Aggregate Index reduces risk (volatility) but with a slight decrease in long term return. The longer the time horizon, the smaller the bond component. See XTF “Efficient Frontier” chart for graphical presentation of the relationship between asset mix and return.

It is much easier to set up a diversified portfolio of ETFs or index funds, than to describe it here. Here are several links to good articles about index investing:

• The “Four Milestones for Successful Investing” by Scott Burns – excellent summary of index investing
• A series of articles by Scott Burns ETF and Index investing
• Examples of “lazy” index fund and ETF portfolios compiled by the Kirk Report
• More articles and examples on ETF and index portfolios at FundAdvice.com
• The “Ultimate Buy and Hold Strategy” by Paul Merriman

Those in who work for the federal government or serve in the military have some of the most efficient index funds available in the Thrift Savings Plan. Nobody offers lower cost or higher quality index funds. For those who do not want to do the asset allocation themselves, the Thrift Savings Plan Lifecylce Funds automatically allocates asset classes based on an anticipataed retirement date.

Where does NAIC-type investing fit into all this? Portfolios that follow the NAIC methodology tend to have a growth style. They also tend to include larger cap stocks. Thus the NAIC portfolio is just one of a number of possible asset classes that should comprise an overall portfolio. By itself, an NAIC-type portfolio does not provide broad diversification, even if the portfolio is diversified among growth stocks.

Here are some details from the S&P report for the 4th quarter of 2006. 

In 2006, domestic equity stocks indices led actively managed large-cap and small-cap funds.  The S&P 500 outperformed 69.1% of large-cap funds and the S&P SmallCap 600 led 63.6% of small-cap funds.  Conversely, 53.3% of mid-cap funds outperformed the S&P MidCap 400.

Over longer time periods, the market indices continue to outperform a majority of the actively managed funds.  Over the past three years (and five years), the S&P 500 has beaten 66.7% (71.4%) of large-cap funds, the S&P MidCap 400 has outperformed 65.1% (79.7%) of mid-cap funds, and the S&P SmallCap 600 has outpaced 80.6% (77.5%) of small-cap funds.

Why do the indices perform better than actively managed funds?  The short answer is that fund fees are higher and many funds do not do a good job of selecting stocks or managing their portfolios.  (Most funds are exceptionally good at collecting fees, however.) A number of funds fail to put the financial interests of their shareholders ahead of their own.  (The recent after hours trading scandal by fund managers is one example.  Another is excessive fees.)

Fees and expenses erode net return on mutual funds.  Management fees typically range from 0.5% to 1.5%.  (In contrast, management fees for some of the largest and oldest index funds are generally less than 0.2%.)  In addition, mutual funds also pay various transaction transaction and portfolios.  These fees are not disclosed in their prospecting but are contained in a statement of additional information.  Some have high turnover of assets.  High portfolio turnover raises expenses, increases tax liability, and often degrades performance.

When evaluating a mutual fund, it important to compare its performance to the index that most closely corresponds to the style of the fund (large cap value, mid cap blend, small cap value, etc.).  Also keep in mind that index funds tend to be more tax efficient.  Low turnover reduces the annual tax bite. 

How do you know if the mutual fund you are considering buying is one of the few that has outperformed market?  First, go to www.fundalarm.com and see how the fund has done over the past 1, 3 ,and 5 years.  FundAlarm.com compares fund performance with the benchmark that most closely corresponds to the fund style.   Second, look at the expense ration for the funds and sales commission.  Morningstar also compares fund performance with an index benchmark.  The management fee for a domestic equity fund should not exceeds 0.8%.  Pass on any funds that charge a load or 12b1 fee.

So what relevance does this have to the Model Investment?  First, it is not easy to beat the market.  We try but do not always succeed.  Second, it is important to minimize transaction fees and expenses.