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Scott Burns' Articles -- Recent and Archived

Using ETFs to Build a Portfolio

Q. I am 47 and work fulltime. I have about $250,000 in my 401(k) and about $150,000 in my IRA from a previous employer. I have invested in the Couch Potato portfolio and in the IRA, and in the past few years have moved to the Margarita Portfolio (I am a Parrothead).

I was going to split $85,000 into your Six Ways Building Block portfolio until I discovered that the Vanguard Energy fund requires a $25,000 minimum. Since Vanguard will have $70,000 of the $85,000, do you know if it will let me invest less than the required $25,000 in the energy fund? If not, any other suggestions as to a replacement for the energy fund? ---V. R., by email

A. No, it won't let you invest less than the required $25,000 minimum. But you have an alternative.

Vanguard also offers an exchanged-traded index fund (ETF) that invests in energy stocks. Its ticker symbol is VDE. You can learn more about it by going to www.morningstar.com, and entering the ticker symbol in the quote box in the upper left hand corner of the page. You'll have to pay a commission to buy or sell this fund, but there is no limit on the size of your investment.

The expense ratio for the ETF is 0.25 percent. It was recently selling for about $80 a share. That means 100 shares would cost about $8,000. If you paid a commission of $12 to buy it, it would add 0.15 percent to the cost--- not a terrible burden.

You might also consider another ETF, the SPDR Energy index fund (ticker: XLE). It has been around longer and has the same expense ratio. The difference between them is that VDE tracks the MSCI Investable Market Energy Index, while XLE tracks the energy stocks in the S&P 500. Both are market capitalization-weighted, so the largest domestic energy companies dominate both indexes. ExxonMobil, for instance, is the largest holding in both and accounts for 22.26 percent of VDE and 22.82 percent of XLE.

I know lots of readers are comfortable and familiar with mutual funds, but uneasy about ETFs--- particularly since you have to pay a commission to buy them. But commission costs with online brokers won't be much of a factor for investors with accounts of $50,000 or so. If you'd like to explore the impact of commissions, visit my online ETF Portfolio Cost Calculator at www.scottburns.com.

My friend Paul Farrell, who writes for Marketwatch, has been critical of ETFs, seeing them as new vehicles to generate brokerage commissions. I share his fear they will be misused that way, particularly as the number and variety continue to climb. A fairly lazy Couch Potato investor, however, won't have much turnover.

Using my online calculator with your $85,000 split between six ETFs and assuming a $12 brokerage commission and annual rebalancing, your annual commission cost would be $72. That's 0.08 percent of your portfolio value. If you could substitute Vanguard index mutual funds for some of the choices, your cost would be still lower.

Q. I am 66, have made some money, and am a saver/investor. I have experienced all kinds of things contrary to my future. My big brokerage firm person put me in a government fund that I now find out is poorly rated. My other big broker churned my daughter's accounts, causing them a tax problem for no reason. My discount broker gave me a bad recommendation on a REIT without doing any research. The bank charges 1.5 percent to manage money.

If I am going to be conservative, expecting 5 percent returns, well, a 1.5 percent fee is 30 percent of my income. In my 66 years I have learned to buy mutual funds from Vanguard or Fidelity, Treasury bills and notes from Treasury Direct.gov, bonds from a discount broker, and CDs from credit unions.

I feel like guiding a younger person to these sources would be a good thing, but then I am not a financial adviser. So, where do you find a financial adviser that charges by the hour? How do you find an adviser that is motivated entirely by an hourly charge, not commissions? I would like to find sources to pass on to my wife, children, employees and other interested parties. ---D.C., by email from San Antonio, TX

A. When the major brokerage houses look for new talent, their first priority is not to find people with experience in accounting, engineering, or some field that might give them a knowledge base for financial advice. They look for people with prior sales experience because that's what the conventional brokerage business is all about. Worse, the only way that salesperson can make a living is by moving your money from one product to another, generating commissions.

A typical wirehouse broker generates about $500,000 in revenue each year and takes home a bit under $200,000. Needless to say, generating that amount of revenue requires moving a lot of money.

The alternative you seek is an organization called the National Association of Personal Financial Advisors. They work on a fee-only basis, charging by the hour to give advice. They may also charge as a percentage of assets managed for portfolio management services. Go to its website, www.napfa.org, click on "Find a Planner" toward the bottom of the home page, and you can fill out a form that will generate a list of NAPFA members in your area.

I've gone to a few of this group's conferences and know some members. They're serious students of personal finance who take the word "fiduciary" very seriously. Brokers and other sales representatives, by definition, aren't fiduciaries because they work for their firm. They don't work for you.

Comments

 

ABModerator03 said:

Dear Scott:

As a financial services professional, I read your column in my local newspaper regularly. It is usually insightful and offers helpful advice. However, you seem to have a bias against planning professionals who receive commissions on investment products (my method of compensation).

I would suggest that, in most cases, those who tout themselves as fee-only, especially those who receive a percentage of assets under management, will cost more than I do. Let me share an analysis:

Assume $250,000 of assets under managment

Fee Only Example - Year one - 8 hrs at $150/hour to prep and present a comprehensive plan. Thereafter, planner charges an annual fee for assets under management. I assumed other investment costs are the same so they are excluded from the analysis.

Commission Based Planner - Uses breakpoints and rights of accumulation to reduce sales charges on A shares that pay a 25bp trail.

In reviewing the attached file, the fee only planning client has less money in his account and has paid more for the planning service than the commission based broker within five years. Even if the fee based planner drops his/her rate to 40bp (something I've not seen), the fee based client has less money within 15 years.

Play with the numbers all you want. Clients who have a rather modest portfolio and a five year or greater investment time horizon will pay less using a commission-based planner. Of course, there are commission-based planners who don't give proper consideration to the cost issue. As a CFPtm, I am obligated by our code of ethics to work in my client's best interest. To me, it means disclosing the various methods of payment for services rendered giving due consideration to cost and investment time horizon.

It is discouraging to have influential people like you create predjudice in the public eye against a fair and equitable method of compensation. I would appreciate an opportunity to discuss how your future articles can be more even-handed in advising clients how to search for a planner who meets their needs.

Sincerely, Peter

From Scott Burns:

Thanks for your note. If you go through my archive you will find columns that point out (1) that a significant percentage of no-load funds will have long term costs that are greater than some load funds and (2) that some investors are well served by advisors who put them in commissioned mutual funds. Generally, the best example of both principles is the used of American Funds. They provide the advisor with a commission but get the client into funds that have a great track record of consistent management at very low expense ratios.

Unfortunately, that is not what most people experience. They experience sales people who offer themselves as advisors, who aren't CFPs, who are selling the product of the moment. The brute fact is that this is how the system works as most investors experience it: commissions, not client needs, drive decisions and sales.

I'm delighted you do a careful and thoughtful job. I understand the distinctions about delivered cost you are making. Unfortunately, you are very, very rare.
February 1, 2007 1:20 PM
 

ABModerator03 said:

ETF's seem like a good way to invest because they are less expensive to own than managed mutual funds. However I like investments with long good track records, Like the T. Roe Price Capital Appreciation Fund. It has had positive annual returns for the last 14 years. Its average annual return may not be as high as some other funds but the lower volitility makes it much more attractive to conservative investore who might want to sell out in any given year without taking a loss. Is this type of performance available with other funds or possibly other venues. I looked at the Vanguard ETF Energy Fund and since it is only two years old there is limited performance data. Is there any way to backcheck the performance of a ETF before its inception.

Thanks for your help.

Thomas

From Scott Burns:

The best way to check the potential performance of an index based ETF is to check the history of the index upon which it is based. It may not be very long, but it will likely be longer than the history of the ETF itself.

T. Rowe Price Capital Appreciation Fund is an outstanding fund. It has shown true value added for a long period of time, something very few managed funds can do. And that's the dilemma we all face. We can take a lottery ticket on management performance, and face losing, or we can buy the certainty of an asset class. Repeated studies have shown that funds that were leaders over a trailing 10 year period are virtually never leaders over the next 10 year period.
February 4, 2007 11:04 AM
 

ABModerator03 said:

Scott:

I read your column yesterday and agree with your position that most brokers (particularly the large wirehouses) are primarily salesmen who work for a large company. I know brokers who work for these firms and it is accurate. However, I feel your recommendation for the National Association of Personal Financial Planners is a narrow solution for investors seeking a broker "who works for you". Out of curiosity, I visited the napfa.org site. I learned three things:

1) You would probably be assured of an advisor who does not have complaints filed with the NASD.

2) You would be hiring a fee-based advisor

3) You would only have two choices in the Seattle area for an advisor.

The growing trend in the financial services industry is the independent broker. I have been affiliated withe one for 9 years. "Affiliated" and "Work For" are two different things. My affiliation (agreement) is that my Broker/Dealer provides me with resources (technological system changes, and compliance changes) that I gladly pay 10% of the fees and commissions that I collect from my clients. Yes, I said "commissions".

You see, whether a client pays fees or commissions has little to do with the success of their portfolio. The number one thing an investor should look for in an advisor is that he or she understands risk and knows how to manage risk. This will be the number one factor in the success of a portfolio. Not that this is an easy thing to discover - I would advise this way:

*Ask people you respect who they use and how long they have used the advisor.

*Avoid large wirehouses. The design of the large wirehouse is to create an effect of "how can we provide a service that appears to be in the client's best interest but is really a game of keeping the clients just happy enough that they won't go away". Branding is a powerful deal.

*Interview at least 3 advisors (this is a long term relationship so upfront work should go into it on behalf of the client) and ask to see their performance of clients in similar situations.

*Avoid advisors who delegate the risk management to money managers, etc.

Investors are crying out for an advisor who understands risk and knows how to manage it. The odds of finding that either of the two gentlemen listed on the local NAPFA being good at risk management is not good.

From Scott Burns:

Thanks for your note. I agree with everything you said except the last sentence. Finding anyone who truly understands risk and invests accordingly is very difficult--- but I do not believe it is less likely with a fee only planner. And while it is possible to do good work on a commission basis--- I have frequently praised the brokers who use American Funds for finding a way to be compensated while delivering low long term cost management to their customers--- the reality is that commissions influence the judgment of those who collect them, witness the fact that those who sell variable annuities are their only fans.
February 5, 2007 8:53 AM
 

ABModerator03 said:

Dear Mr. Burns,

I read your column each week in the Business Section of the Sunday Seattle Times. Most of the advice you offer to readers seems to be reasonably sound and well thought through. Your column yesterday "Find An Adviser Who Works for You" put brokers who work for brokerage houses in a very negative light. According to your article, all brokers try to maximize the amount of commission they can generate from their client's assets. While I readily acknowledge that there are individual brokers who operate in exactly that manner, you stuff all of us into that same convenient category.

I have been a broker for 36 years with 3 regional brokerage firms. If I treated my clients during my career in the manner that you infer all brokers do in your column, I wouldn't have any clients today and would have found some other vocation long ago. Over the years I have known many brokers who put their clients first and go to great length to help them achieve their investment objectives. Sure, experienced brokers are well compensated but they should be because their clients make money and achieve their financial objectives.

Lots of press is given to the "bad apples" in my profession. Because of this fact, brokers make easy targets for a journalist like you. If you would take a little time to dig a little deeper you would discover there are many brokers who do a great job for their clients by offering superior service and sound investment counsel. Their clients depend on them for financial advice and establish long standing relationships with them. The part you have missed is that good clients are hard come by. If a broker treats a client as he/she would want to be treated or maybe better yet as he/she would expect their mother to be treated, there is good chance of establishing a long term relationship that is mutually satisfying. The experienced, successful brokers I have known operate in this manner.

Your conclusion was brokers work only for their firms. They don't work for their clients. From my experience, your conclusion couldn't be further from the truth when it comes to a good broker. Years ago my late mentor told me, "Your clients are your social security. If you take good care of them, they will take good care of you". I have found that to be the case for the last 36 years.

Dick

  

From Scott Burns:

I have friends who are brokers who do exactly the kind of work that you say you do, so I know you are telling the truth when you say there are good brokers. Indeed, my late stepbrother was a career broker. When he died a client of 20 years delivered his eulogy. I think that tells you something about service. Unfortunately, brokers who have a large enough book of business to defy the selling orders of their branch managers are a small minority and you need to come to grips with what the average customer is likely to experience.

Also, the distinction I made about who you work for was literal, not metaphorical. If you are a broker, you work for the brokerage house and the client can only hope for reasonable and appropriate investments. This is different from being a fiduciary where you are legally bound to serve your clients interests first, including providing the lowest possible costs. This is a distinction that the CFP group is making much of because it tends to get blurred when the brokerage community talks about providing advice. Language, however, is important because it directs behavior.
February 5, 2007 9:05 AM
 

ABModerator03 said:

Dear Mr. Burns.

I inquired a couple of weeks ago about a fee only financial advisor. Glad to get a lead from you I contacted www.NAPFA.com, found an advisor, and went to visit him. If they indicated they are interested in advising people on an hourly basis, they are not, it is just a lead in. They are interested in managing a portfolio on a percentage, annual fee, like 1.2%. So, if you were getting older, wanted to move conservative to CDs, muni bonds, treasuries that yielded 4-5%, and your portfolio was $2,000,000 that would earn about $90,000. The advisor would charge you 1.2% or $24,000 to free you from having to worry about your finances. Am I looking at this wrong, or is it a rip off. I think sticking with my big brokerage firm, letting him earn some money buying and selling something once in a while is a lot better investment than paying $24,000 to earn $90,000.

Donald

From Scott Burns:

Many advisors have a split-fee arrangement, recognizing that charging 1.2 percent for fixed income investments is silly. A more typical rate for fixed income is 0.5 percent.
February 7, 2007 4:55 PM
 

ABModerator03 said:

Well, here I am again, with more feed back. After visiting with the fee based financial advisor that I found through NAPFA, the bottom line was that it would cost 1.2% a year for a $1,000,000 portfolio, or $12,000.

The same assumptions with my UBS account cost me $2,500, or .25%. That includes commissions fees etc. So if they churn you a little, so what.

I think it comes down to the person you are dealing with. If it is a 30 year old working hard to earn a living and needs to crank up those fees that's one thing compared to a 47 year old UBS broker that has a substantial book of business, and experience.

After all of this searching and experience on my part, this one man seems to rise to the top. I have a new appreciation for him and have a good understanding about how to approach the future in regards to assistance for my wife and daughters.

Thanks for your help

Donald

From Scott Burns:

Thanks for the information. You're right about the age issue with the broker--- or at least some brokers. Experienced brokers with a big book of business can make a good living without extracting big fees from their accounts. The hard part is getting to that position. The 1.2 percent fee your were quoted strikes me as a tad high for a $1 million + account. Typical fees run around 1 percent and many firms have somewhat lower fees.
February 8, 2007 8:53 AM

About scottb

Scott Burns has covered the changing world of personal finance and investments for nearly 40 years. Today, he ranks as one of the five most widely read personal finance writers in the country. Scott began his career as a newspaper columnist at the Boston Herald in 1977 where he was also the financial editor. Nationally syndicated in 1981 and now distributed by Universal Press, the column appears in newspapers from Boston to Seattle. In 1985 he joined the staff of the Dallas Morning News where his column quickly became one of the most widely read features in the paper. He left the Dallas Morning News in 2006 to become one of the founders of AssetBuilder and its Chief Investment Strategist. Burns is a graduate of Massachusetts Institute of Technology (1962). He has written four books, including "The Coming Generational Storm" (MIT Press, 2004) coauthored with economist Laurence J. Kotlikoff. His fourth book, also coauthored with Kotlikoff, will be published this spring by Simon & Schuster. "Spend Til' the End" uses consumption smoothing to demonstrate the errors of conventional financial planning. His business experience includes working as a staffer for a major consulting company and service as a director and audit chairman of a NASDAQ listed manufacturing company. He and his wife divide their time between Dallas and Santa Fe, New Mexico.
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