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 Treasury Inflation Protected 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.

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 advance. 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 instance, 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 brokerage firms penalize brokers for dealing with "small" accounts. 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 3 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 8 ETFs that you rebalanced 4 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 percent average annual expense ratio of the 71 largest moderate allocation mutual funds--- those with assets of at least $10 billion under management.

Limit your portfolio to 4 or 5 ETF choices, and your total expenses, including the expenses of the underlying funds, would likely be less than 60 basis points (0.60 percent). 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 American Funds group can make that claim--- but they all have upfront 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 5 or 6 ETFs, rebalance it 4 times a year, and your expenses will be about a tenth of one percent. You could, in other words, manage 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 subtract from every holding when you add or rebalance, so expenses are likely to be somewhat lower.

This is a major opportunity for individual investors.

Want to explore this for yourself? Try my online calculator,
More:

Index and ETF Investing