Q. Aren't you overlooking something when you advocate buying ETF's as opposed to regular mutual funds? When buying an ETF, you have to pay a commission on both the purchase and the sale. This can be expensive for an individual that wants to buy a small amount on a periodic basis.

Let's say you invest $100 once or twice a month in an ETF and take advantage of dollar cost averaging. Each time you buy you would probably have to pay $8 or so in commissions. That works out to be 8 percent of the purchase price not counting the sale. The mutual funds I invest in may charge an annual fee of about 1.5 percent, but it doesn't cost me anything to buy or sell them.

Am I missing something in your advice?

---J.C., by e-mail

  

A. When I write about Exchange Traded Funds it is to inform investors that there is a new and interesting alternative to traditional mutual fund investing. It is not a blanket endorsement of ETFs as a 100 percent substitute for mutual funds. One of the reasons they aren't a full substitute is the commission cost you mention. The higher the commission, the more reason you have to stay with traditional no-load fund investing.

Now let's examine the relationship between management costs, commissions, and investing in ETFs. Suppose you own a disappointing managed fund with an expense ratio of 1.5 percent. How long will it take to recoup the commission cost of moving to a low cost ETF?

Not very long at all.

The original S&P 500 Index Spyders (ticker: SPY) have an annual expense ratio of 0.12 percent. The competing iShares S&P 500 Index ETF (ticker: IVV) has an annual expense ratio of 0.09 percent. The iShares Russell 3000 Index EFT (ticker: IWV), which captures virtually the entire domestic stock market, has an expense ratio of 0.20 percent.

In 12 months a mere $1,000 in the average managed fund will cost you $15 in expenses. During the same 12 months the most expensive of the three ETFs mentioned above will cost you $2 in expenses. You'll recoup an $8 commission in about 7.5 months. After that, you'll continue getting a "return" on your commission "investment."

Another thing you can do is "park" your money in a no-load mutual fund that is similar to the ETF you want to invest in until you have enough money to make a transaction worthwhile. Fidelity Spartan 500 Index fund (ticker: FSMKX) has a minimum initial investment of $10,000 and an expense ratio of 0.19 percent. That means it costs $19 a year to manage their minimum investment. Invest the same amount of money in the iShares S&P 500 index ETF, however, and you'll recoup the $8 commission in expense ratio savings (0.1 percent a year) in less than 10 months.

If you are a new investor with a small account, ETFs probably aren't for you. But if you are an established investor with $50,000 or more to invest, you can use ETFs to build a very low cost diversified portfolio.

Here, for instance, are five basic building blocks:

•  Vanguard TSM VIPERS (ticker: VTI) replicates the entire domestic stock market at an annual cost of 0.15 percent. The average managed domestic stock fund has an expense ratio of 1.56 percent. That's ten times as much as the ETF, according to the Morningstar database.

•  iShares MSCI EAFE (ticker: EFA) replicates the broad Morgan Stanley international stock index at an annual cost of 0.35 percent. The average managed international stock fund has an expense ratio of 1.90 percent.

•  iShares Lehman TIPS (ticker: TIP) indexes the Treasury Inflation Protected Bond market at an annual cost of 0.20 percent while the iShares Lehman 7-10 indexes the intermediate government bond market for 0.15 percent. The average managed intermediate government bond fund has an expense ratio of 1.14 percent

•  street Tracks WR REIT index (ticker:RWR) follows the Wilshire REIT index at an annual cost of 0.28 percent. The average managed fund specializing in real estate has an expense ratio of 1.66 percent.

In addition to saving well over 1.0 percent a year in expenses in most categories, these broad funds have much lower portfolio turnover and related costs. Moreover, 9,400 of the 14,000 conventional funds that accept minimum initial investments under $10,000 also carry upfront or deferred commissions. So most of the funds out there are commissioned.

Small wonder some observers are predicting a future decline for the conventional mutual fund industry.

On the web:

Read Doug Fabian's comments on the future of mutual funds at John Mauldin's "Front Line Thoughts"

Learn More About ETFs at these sites:

http://www.morningstar.com/Cover/ETF.html?topnav=etfs

http://www.ishares.com

http://www.amex.com/