Just read your column "Still More Couch Potato Building Block Portfolios" and again many thanks for all you are doing in the field of personal finance. I appreciate it.

Mike

From Scott Burns:

My pleasure. These columns are drawing a lot of interesting questions.

I would first say I like the concept of layers. For actively-involved investors, one could see a non-contributing layer and delete it until it shows promise. For less-active investors, this could be just what the doctor ordered. I would caution some though that this model may, or may not, be so successful during unforeseen times ahead. Including REITs, energy, and emerging markets...all the darlings of recent years, with the same 10% weight....may not look so good 10 or 15 years from now. If this had been developed eight years ago (1999) it might have had an Internet layer and a Technology layer, you'd still be trying to dig yourself out of that hole. Don't get me wrong...I like it...just food for thought.

Steve in San Antonio

From Scott Burns:

It's certainly true that some (virtually all) of the blocks have had bad periods. It's also true that the trailing 1, 3, and 5 year returns are far greater than anyone should expect as long term returns.

Similarly, the portfolios have relatively low levels of volatility, as measured by their standard deviations. Those low levels don't represent what is historically likely, either.

So the long term returns are likely to be lower and the long term volatility is likely to be higher.

The portfolios, however, were not assembled in a rear view mirror.

The first six building blocks are the basic portfolio formula we used in "The Coming Generational Storm." That book, coauthored with economist Larry Kotlikoff, dealt with unfunded government liabilities and the inevitability of future inflation. So we recommended a portfolio that emphasized investments that will likely benefit from a declining dollar and rising inflation--- TIPS, REITs, international bonds, and energy. The book was outlined in 2002, written in 2003, and published in January 2004.

The new blocks emphasize the additional returns to be had by investing in small cap and value stocks, as per the Fama/French research.

My concern with the added blocks is that the percent in equities becomes too large. The stats are all based on the last five years which has been very favorable to equities. The growth of small caps and international stocks have been particularly strong.

From Scott Burns:

That's why most of the portfolios have a 50 to 67 percent equity commitment. If the larger commitment to equities (of whatever kind) makes you nervous, use one of the portfolios with fewer blocks.

The likely future here is that virtually all of the equity asset classes will have lower long term returns than they have enjoyed in the last 5 years. It's also likely that these portfolios (and all other portfolios) will have a lot more volatility in the future than they have had in the last three and five year periods.

According to the Ibbotson Yearbook, for instance, large cap stocks produced an arithmetic average return of 12.3 percent a year (10.4 percent as an annualized geometric rate) and had a standard deviation of 20.2 percent. Note that the standard deviation is much larger than the average return.

More recently, the Vanguard 500 Index fund returned 10.3 percent compounded over the last 3 years but a standard deviation of only 6.9 percent.

Scott, it would be interesting to see the performance of these portfolios if the asset of allocation of stock vs bonds is held constant instead of having the stock allocation continuingly increasing.

Take a typical 60/40 portfolio and allocate the bond portion at 50% inflation protection and 50% international bond and allow that to remain constant while only the stock portion is adjusted with each new addition.

This would also be a more real world portfolio because I would doubt that most people over the age of 30 would really want to allocate 80% of their portfolio to stocks.

From Scott Burns:

What you suggest would be an interesting exercise but I'm trying to keep things simple so they are more likely to be done. In my experience lots of people are interested, understand, and motivated to be independent investors but many fail to take the last step---execution. So simple is good and may add more value by being doable than a complex plan that would do wonders but never gets done.

There are many reasons someone over 30 could choose to invest more than 50 percent in equities. Here's a personal example: Although I am now 66 I have been 70 to 80 percent committed to equities for about 5 years. Since my retirement income will include a significant pension, I feel I can take the risk. I am likely to lower the equity commitment after I turn age 70 1/2 and need to take required minimum distributions.  

These portfolios seem to keep adding what was hot the previous year or two. First it was just us stocks and bonds when they were hot (and remember people said you didn't need to add international because us companies had international exposure?). Then reits, small caps, energy, emerging, international all seem to get added after they have banner years. I'd like to see how all of these allocations test over the past 30 years (albeit I know some of the indexes are too new for that but perhaps it can be approximated). Is this chasing the next big thing or are these real prudent allocations for the long haul? I don't know, I'm just wondering.

From Scott Burns:

Please read my response to Steve. It addresses the question you ask.

Scott

I'm new reading your articles, so I may have missed something. When you started out with the Couch Potato Plan, and subsequent expansions, your proposed fund selections were almost all index funds. This latest portfolio is almost all ETFs. I read the previous article which said for accounts over $11,000+ the ETFs would have a lower expense, but aside from it I've not seen anything that would cause you to drop index funds in favor of the ETFs. Did I miss something? I plan on setting up a portfolio worth about $35000 total.

Steve

From Scott Burns:

The more components in your portfolio, the greater the odds you will use an ETF index instead of a mutual fund index. If you start with a two or three Building Block portfolio its pretty easy to do it with mutual funds.

Add more blocks and it gets harder.

Also, much depends on where you build your portfolio. If you do it at Vanguard you'll have a broad choice of index mutual funds. If you do it at Fidelity, you'll basically be restricted to Spartan Total Market and Spartan International, so you'll need to fill in the other spots with ETFs.

Why ETFs? Because the brokerage commission for buying an ETF is a fraction of the charge for buying a low expense index mutual fund.

Mr. Burns:

First off, I am an avid reader of your articles and website. I was rather excited to see some of the new 'blocks' you introduced as I have long held positions in Emerging Markets, Foreign Large Value and Foreign Small/Mid Value funds to help supply an added measure of diversification and return. It was nice to see that I was not completely off the mark.

In this recent article, "Learning to build with more blocks" you state returns for portfolios which include ETFs that have been in existence for less than 5 years. In fact some of the ETFs in the 'new block' portfolios have been in existence for only 1 year (EFV, VDE, VNQ, VWO). That being said, how were the 3 and 5 year returns calculated for the portfolios which contain these new blocks (which mutual funds were substituted for the ETFs)?

Many regards,

Bill

From Scott Burns:

The calculations were done using Morningstar Principia software and data for Vanguard/American Century mutual funds. Many of those Vanguard mutual funds are now available as ETFs.   The Vanguard Energy ETF was not available until a year ago but a managed fund, Vanguard Energy (VGENX) was. Alternatively, the Energy SPDR index (ticker: XLE) was available for the full 5 years.

Just finished reading your building block method and have one question--what is the difference in cost for the long haul--five years holding time--between say Vamguard mutual fund annual fee or ETF-----enjoy your column---Joe

From Scott Burns:

The difference will depend on two things: the size of your portfolio and your rate and frequency of new investments or rebalancing moves. For larger, existing portfolios I think the cost difference will be nominal. For smaller portfolios that are still accumulating with regular additions, the most efficient path will be mutual funds or a combination of funds and ETFs that reduces the number of commissioned transactions.

Scott-

My biggest concern about "value" funds, "growth funds", and other style-based funds is that they are often not well diversified across sectors. For example, the ishares EAFE value fund has 43% committed to financials vs. 29% for the broader EAFE. I don't want half my holdings in financial stocks when the markets head south. The ishares EAFE growth fund actually has much better sector balance than the EAFE value fund - only about 16% in financials which are weighted similarly to six of the remaining 10 sectors that are represented.

As another example, small cap "value" funds tend to be loaded with REITs and correlate well with one's REIT index fund holdings, thus reducing sector diversification.

It seems to me that the sector effect is confounded with the style effect, particularly where "value" vs. "growth" is concerned. Has anybody ever looked at this? I think the failure to analyze the sector weightings of one's equity portfolio is a problem. If I were buying individual stocks instead of funds or ETFs, I think I'd be careful to spread my bets across business sectors. I wonder if the best approach to equity diversification would be to use the 10 or so existing sector ETFs as the building blocks and invest equal amounts in each one? Hey, why doesn't somebody come out with style-based ETFs (e.g. value, capitalization weight) that have equal sector weights?

From Scott Burns:

This is an area where it is better to use actual figures than adjectives. Recently, for instance, I checked the Russell 2000 Value index and found that it was 11.3 percent REITs. That's a pretty big slug but it's a long way from loaded with REITs and it's after a spectacular 5-year run.

So I'm not particularly worried about being overweighted in REITs. I do think it unlikely that they will provide the spectacular returns of the last 5-years in the next 5-years.

Years ago Mario Gabelli joked about what you were really buying when you bought shares in emerging markets--- those markets tend to be dominated by banks, breweries, electric utilities, and a phone company...

Today, the global concentration of financial stocks is worrisome. The iShares Australia ETF is a good case in point. While everyone thinks of Australia as a Jim Rogers-like commodity play, it turns out that 49 percent of the ETF portfolio is in financial services. This compares to 32 percent for Canada and only 16 percent for Brazil. (Financials are about 22 percent of the S&P 500.)

If we examine financials as a percentage of total portfolios (including fixed income) here is what we find:

Portfolio	% Financial	Added Block
Crispy Couch Potato	11.2 pct	(50/50 U.S. total market, TIPS)
Margarita	17.2	add International equity
Four Square	12.4	add International bonds
Five Fold	29.8	add REITs
Six Way	25.2	add energy
7	26.0	add U.S. large cap value
8	27.4	add U.S. small cap value
9	26.8	add Emerging markets
10	28.4	add Large international value

Scott,

Could you provide the trading symbols for these 10 blocks?

I assume there are more than one for each Block?

Thanks,

Lonnie

I really like your ten way split, as it provides a lot of flexibility in updating/deleting/replacing different layers without distturbing the entire portfolio. However, I am concerned with ten layers my initial investment sum has to be much larger to reduce the cost of investments. Do you have any advice on which one of ten portfolios is better if you had $20K versus $500K!!

Thanks for writing such enlighening arcticles.

KAS

From Scott Burns:

With $20,000 I'd be inclined to use the Margarita portfolio. It would provide broad investment in domestic and international equity markets and inflation protected investment in U.S. Treasury obligations. It's simple and basic but well diversified--- and you'd have more than enough money to make it cost efficient.

One of the nice things about the building block approach is that you can add blocks as your portfolio grows.

Scott-

Thanks for your analysis of the percentage of financial assets in each of your portfolios. I am concerned it is so high. Given that there appears to be a fairly standard breakdown of broad index funds or ETFs into about 10 major business sectors, it still seems to me that it doesn't make sense to construct a portfolio in which one equity sector is as high as 25-30% of the total - as is the financial sector currently. A fundamental case can be made for overweighting energy, but I can't think of a fundamental case for intentionally or unintentionally overweighting the others just because they happen to be overweighted in current market indexes.

I've been following the endless discussions in the media regarding the "flood of liquidity" washing over the world's financial assets and it seems to me that this phenomenon has produced two worrisome results for investors going forward: the surge in the concentration of financial stocks in most equity indexes as noted, and correspondingly extremely high correlations between the returns of different equity indexes. For example, the correlation of the Russell 3000, EAFE, and EEM (Emerging Markets) over the last 3 years approach or exceed .90 and are near unity over the last year. In fact, holding the EAFE was pretty much a proxy for holding a more volatile (higher risk) version of the U.S. market. Yes, foreign stocks did better than U.S. stocks but not on a risk-adjusted basis.

Likewise, the correlation of U.S. small cap value, large cap value and the total market have been very high. Presently, little or no diversification benefit seems to be available through holding a basket of various equity index funds or ETFs. On a risk-adjusted basis there is probably very little to gain by going to the trouble.

I speculate that the wave of liquidity spoken about has pumped tons of cash into every nook and cranny of the equity investment landscape. That will change in the future, but probably not before some huge turmoil in the equity markets scares away all that capital.

I suspect that the good old Couch Potato and Crispy Couch Potato portfolios are still the best on a risk-adjusted basis, because there is still a pretty small correlation between stock and bond returns. The free lunch that used to be available by splitting up equity holdings into various types of index funds or ETFs may no longer be free, or be as tasty?

From Scott Burns:

I share your concern. So do others, witness an article in today's Wall Street Journal on how hedge funds may be heading for a rough time because differences between investments are shrinking.

That said, I'm not sure what to do about it without becoming a market timer or sector rotator, roles index investors should avoid like the plague.

Hi Scott, I have two quick questions about "couch potato investing."

First, in your book "The Coming Generational Storm," you mention that investing in gold might be a good avenue to counter the coming wave of inflation. Would adding gold/precious metals to this portfolio instead of TIPS be a good decision? (I'm wondering b/c TIPS are dependent on the US Govt. CPI figures, which compared to "Real World" inflation, are grossly understated)

Second, if an investor should maintain this allocation of the lazy portfolio, should precious metals be added to one's portfolio at all?

Thanks for your help.

From Scott Burns:

Gold is an insurance idea more than it is an investment and the "policy" rarely pays off with big gains. The last few years have been good. So were the late 70s. But the intervening years were barren.

Bottom line: the best alternative to dollars I can think of is oil, hence the energy building block.

Scott: Would you provide a list of Vanguard mutual funds for the 10 speed portfolio? Also, don't you think that most people would find a portfolio of ten different funds to be excessive and much more difficult to maintain, and later withdraw from, than say just five?

Thanks, Dodger

Because of an excellent and fully funded pension and SS from nearly 50 years of working I continue to stay heavily in in equities. I have two IRA's and take my RMD out of the more poorly performing one. I continue to add to the rest of my portfolio on a monthly basis so I do not anticipate trying ETF's. While not classic Couch Potato my portfolio is pretty basic and mirrors the Four Fold.

Thanks for the education, Scott.

Don in Jacksonville, FL

Scott,

What is the reason behind the International Bonds. I'm not sure I've seen this decribed before. Why not buy something like AGG for example?

I'm using your 7 way with VTI, , EFA, VDE, VNQ and AGG, TIP, VWO. i like the emerging market better then more US markets. I don't mind the risk. What's your thoughts on that strategy.

Scott:

What am I missing? I have a larger portfolio, but don't understand why I would want to use a smaller number of blocks. It seems to me that age and risk would be the determing factors. I also don't understand how index mutual funds would keep my cost lower than ETFs.

Robvan

Congratulations Mr. Burns, You've finally realized what the professionals have known all along. Diversification is the answer to more consistent returns and reduced risk. How odd that it took the S&P underperforming many other indices for you to notice this. Perhaps a retraction as to the value of your couch potato strategy is in order? After all, had people followed your original advice, they would have drastically underperformed in the last few years.

From Scott Burns:

That's a cheap shot. Underperformed relative to what? And over what time period?

The reason I started the Couch Potato approach was that testing showed that it had done better than most managed funds over longer time periods and it was clear that self-directed investors needed something that could be done very easily.

In the late 80s, when I started writing about the Couch Potato approach, 401(k) plans were relatively new, index investing was in its infancy, computer and internet use were relatively rare, and international investing was mostly an idea.

At the end of 1989, for instance, my copy of the 1990 Mutual Fund Fact Book tells me that International and Global Equity funds accounted for only 1.8 and 2.5 percent, respectively, of the $554 billion mutual fund industry. There were few international funds. Many of those were for institutional investors. There were no retail international index funds until 1990. The first international ETFs weren't launched until 1996.

Things change.

Today we have a multitude of index mutual funds and ETFs that don't require institutional checkbooks. We now have tools that simply didn't exist as recently as 10 years ago.

And how has the Couch Potato portfolio done? Check these figures from a recent speech by John Brennan at Vanguard,

" Scott Burns' original Couch Potato Portfolio consisted of 50% Vanguard 500 Index Fund and 50% Vanguard Total Bond Market Index Fund-so simple it could be managed from the couch with one hand on the remote and the other in the pretzel bowl. From 1992 to 2005, the portfolio returned 8.7% per year. You could have spent many hours trying to create a similarly weighted portfolio from the multitude of stock and bond funds at your fingertips, but you would have earned, on average, almost 1 percentage point less, according to data from Lipper Inc."

I think a 1 percent annualized advantage over 14 years speaks rather well for the Couch Potato approach.

On 2-7-2007 you had building blocks 1-6 including the risk or standard deviation. On 2-11-2007 you had building blocks 1-10, but no risk measurement. Please include the risk so people in or near retirement can use the info better. I like high returns as well as the next person, but I will only take so much risk. Thanks, Al

From Scott Burns:

The most recent column, which includes Building Block portfolios with from 2 to 10 blocks, includes the standard deviation and beta figures. I included these figures with some trepidation because they are for the last 3 year period which was marked by unusually low volatility. Since it was also a period of unusually high returns, I think we should expect higher volatility and lower returns in the future. I'm thinking closer to historical norms.

The figures are in this column above.

Dear Art -

I'm sure Scott is quite capable of defending himself but I'd like to remark that if you really understood diversification, you would realize that it involves holding multiple assets with low intercorrelations. The 10-speed portfolio has 70% of its assets in 7 stock funds, all of which were highly correlated last year (except for Energy), 20% in bonds, and 10% in REITS. The Couch Potato has 50% in stocks and 50% in bonds, which correlate near zero. So which is really more diversified? Last year, stocks did much better than bonds. No surprise the portfolios that were heavier in stocks did the best. But you wouldn't have been so happy with them back in 2001-2002 when stock funds were all down in the double digits and bond funds were way up because of falling interest rates. The main purpose of diversification is to mitigate losses, not to maximize gains. Next time the stock markets are down, you might have a different perspective on the good old Couch Potato.

Regards,

BillE

From Scott Burns:

The greater the number of building blocks, the greater the concentration of equities and the greater the risk--- as measured by standard deviation. While the ideal portfolio would be build with asset classes that have negative correlations to each other, the world is not being very cooperative. The more we globalize, the greater the correlations between asset classes.

In the end, we have to go with the asset classes we've got. The good news is that the more building blocks you use, the broader your diversification across equity asset classes and there have been long periods in which international equities have done materially better (or worse) the domestic equities.

Scott: we are considering restructuring our investments utilizing the couch potato. We have quite a bit of our investments already in various mutual funds via our 401K accounts. In our 'taxable' investments, however, we have a mix of equities, mutual funds, bonds, and cash (like CD's). What I have noticed at tax time is that we have to declare any capital gains made by the mutual fund for that year on our personal tax returns for those that are not in a 401K or an IRA . I find it problematic in several ways: 1. we have no control over what year we take these gains, 2. we don't get to declare capital losses in the years the mutual fund accounts have a capital loss, 3. we don't personally realize any gain or loss on the mutual fund until we sell, 4. It's a situation where ultimately we get double taxation at the time we sell, unless we are particularly astute on how to not get taxed the second time. Not sure how the record keeping would be done on that. That being said, the taxes don't necessarily wag the dog, but they do impact the bottom line. So my question is, with the Couch Potato investments, do they still make sense outside of a tax protected environment? How does that factor into the equation?

From Scott Burns:

You don't ever pay double taxes on mutual fund gains. What can happen, however, is that you will pay taxes on (1) the unrealized gains in the fund when you buy it and (2) on gains that accrue after the purchase. If you buy a fund with substantial unrealized capital gains--- called "buying a tax liability"--- you will pay taxes on gains you never experienced.

The best ways to minimize this are to:

(1) check the unrealized gains of a fund before purchase. If one has large unrealized gains and a similar fund does not, give preference to the one with the least in unrealized gains.

(2) make sure major fund purchases are made AFTER big capital gain distributions. Since these are usually made in late November or early December, late December/early January is a good time to make major shifts.

The unrealized gains issue isn't always a negative because there are times when funds have large realized losses that they carry forward. This means the fund can develop new gains and you'll never have to pay taxes on them until the loss carry forwards are absorbed. Morningstar regularly estimates such figures.

While all investments are easier in a tax-deferred environment because you have no tax considerations, the Couch Potato portfolios work well in both because they are based on index mutual funds, most of which are quite tax efficient. ETFs are believed to be more tax efficient than mutual funds.

I understand and share the concern about the large % of financials in some of the portfolios, but wonder if that is the nature of the beast. I don't have the sense of history to know.

"Value" investing means finding out of favor companies, and it seems to reason that like individual companies, whole sectors can go out of favor (think small caps back in the 90's when everyone was in love with large growth companies), and thus if we could go back in time we might find that 10 years ago there was a worrisome % of sector X in value portfolios, and 20 years ago it was a worrisome % of sector Y, etc. Yet all along, given time, value investing has provided strong returns with good reliability.

If that is so (maybe it is, maybe not), while I remain a little concerned, I don't think I'd worry too much about this concentration.

As an aside, I love the building block approach and largely have my accounts set up this way. History can teach us broad truths, but not fine scale truths: stocks are likely to out shine bonds in the long run, but who knows about the short run. Same with value vs growth, there is value in not putting all your eggs in one basket, etc.

One can have lots of fun with fancy allocation analysis software, but while you might get an answer to use 11.76% S&P 500 using one dataset, you might get 8.39% using some other dateset (say a different set of years), and in the end the future will certainly tell you that you should have used some other %. So while it is tempting to spend great effort to super fine tune the numbers, ultimately it does not make sense, and one might as well use nice round numbers. They need not be all the same, if you want more bonds say you might just double up the share of bonds or something. But there is great sense in keeping it straight forward.

Thanks, Rod

From Scott Burns:

Most of the reader mail I see reveals that people who save and invest tend to have their assets scattered over different accounts and many different investments. It's difficult to even determine what their asset allocation is, let alone make decisions about it.

Scott-

A quick question regarding the performance figures shown in your table for each of the Building Block portfolios. I wonder if you can indicate how these were calculated? My figures generally show lower returns and lower standard deviations for each portfolio and are based on monthly returns and include periodic re-balancing to the target allocations. I'm guessing your's don't take re-balancing into account and therefore the ending percentage allocations are quite different from the beginning target allocations thereby increasing portfolio volatility. How often do you recommend re-balancing these portfolios, and do your performance figures reflect this? Thanks.

BillE

From Scott Burns:

The calculations were done by Morningstar Principia software using their "unscheduled portfolios" feature. According to their software documentation the calculations are based on monthly rebalancing with ending allocations exactly equal to the allocations you set.

As a practical matter, I believe that's more rebalancing than most people should do because it will involve trivial amounts. It would also be expensive, particularly for those with ETF portfolios rather than mutual fund portfolios. The object of the Building Block portfolios is to make things simple and "do-able" and we do this by avoiding excessive (and often meaningless) precision.

One concern I have with the reported results is that the returns are a good deal higher than historical averages suggest and the risks (as measured by standard deviation) are a good deal lower. The SD figure is for the preceding 3 years which was a period of unnaturally low volatility.

Scott,

In the above article you gave an option of EFT or Mutual Fund for the REIT and Energy where you previously had only the funds.

1. I assume you have no strong recommendation on one over the other 2. What are the returns shown based on, funds or EFT's? Or does it make much difference?

I am tracking a modified Six Way from Jan 1, 07 against my managed portfolio. I substituted Loomis Sales Strategic Income-A (NEFZX) for the TIPS. (It is in my portfolio now. I can buy at Net Asset Value). If the modified Six Way continues to outperform my portfolio I will probably change over to it.

I am retired with about $1.4 Million in my portfolio. Age 67.

You must get thousands of emails. If you can comment I would appreciate it.

Thanx, Tom

From Scott Burns:

What you do depends on where you have an account and how much money you have. In your case, commissions will be a trivial expense so you should go for ETFs on the brokerage platform of your choice.

Watch the website. I'm putting together some specific "recipes" for different platforms and should post it soon.

Hi Scott,

I'm looking at the front page of thestreet.com. They were the first ones to start blowing the whistle on Enron, and I enjoy some of the free articles there.

There are 2 articles in the thestreet.com Managing Your Money section: "John Bogle is Wrong About ETFs. The Vanguard Legend is mistaken: ETFs are a good tool" and "Cramer's Got It Wrong on ETFs. He says they're a scam. Not so."

So it looks like there is some controversy about ETFs. What do you think, Scott?

From Scott Burns:

I think ETFs are an important new tool. I also think that just as a multitude of mutual funds have no reason to exist, a large number of ETFs have no reason to exist.

ETFs are a good way to build broad, diversified portfolios at very low cost. Most of the ETFs you would want to own have expense ratios well under 40 basis points and it is possible to build a broad portfolio at a cost of less than 25 basis points. The most expensive of the ETFs that I find interesting is the Powershares RAFI 1000 index fund, at 60 basis points.   At that expense level, the cost of brokerage commissions is not very important. (You can check that by using my online calculator).

If you build a broad, well diversified ETF portfolio--- one without gimmicks--- and only trade to rebalance you'll have made a very intelligent use of this new tool. If you trade gimmicky ETFs because you think they'll go up today or this week, then Wall Street has just found another way to make money off your money.

Scott,

I am interested is starting your 10 Speed portfolio & ran into some surprises with commission costs.

Your article assumes a $12 commission per trade. TD Ameritrade wants $49, and Fidelity and Southwest Securities (my present IRA custodian) both want $75.

Where can I find $12 trades for these funds?

Thanks!

Don

From Scott Burns:

You get $12 (and lower) commissions when you buy stocks. ETFs are considered stocks and trade like same so you get stock commission rates. You pay a different commission if you buy a mutual fund, generally ranging from $50 to $75.

One way to reduce costs is to have an account at Vanguard if you want to limit yourself to funds. I've been managing my accounts at Fidelity where I used their Spartan index mutual funds, with no commission cost, for domestic and international total markets and then add in ETFs at low cost commissions for the rest. American Century International Bond fund is problematic both as a fund and as a purchase--- as I've written in columns, I am hoping there will be a short term foreign fixed income ETF this year.

Do you have any comment on the article of Mr. Bogle in the WSJ 9FEB07 concerning ETFs?

It is available at http://johncbogle.com/wordpress/wp-content/uploads/2007/02/WSJ_2-07.pdf

He lists some drawbacks to ETF that might have bearing on several of you building blocks.

P

From Scott Burns:

ETFs are a bit like wines. You can be a selective drinker who enjoys good vintages or you can live on the street with a bottle of Thunderbird. The first is healthy, convivial, and good for you. The second will kill you. I think Bogle is right to respond negatively to the plethora of narrow slices and speculative vehicles being offered--- Wall Street Thunderbird--- but wrong to excoriate the entire vehicle.

Indeed, one very good use for ETFs was pointed out in today's WSJ by Jonathan Clements--- using inexpensive fixed income ETFs to replace expensive broker proprietary fixed income mutual funds.

As much as I respect Bogle (not to mention enjoy his sharp sense of humor), I think his specific attack on the Fundamental Index concept created by Rob Arnott is misguided. They represent a new class of index funds that may overcome some of the negative features of traditional cap-weighted funds. They're a bit expensive as ETFs (60 basis points), so I'd like to see their expense ratio at a lower price point. But Arnott's extensive back-testing indicates a return pickup of about 200 basis points and a small drop in volatility. That's a nice combination.

Scott-

Well-spoken words in response to my various rants in this commentary. I was particularly interested in your reaction to the fact that the correlations between various asset classes have been growing in recent years, which seems to make it harder to realize the benefits of diversification. Your concern noted above that returns have been a good deal higher and volatility unnaturally lower than historical norms seems consistent with this development to me. Too much credit chasing too few assets is the common denominator.

Your observation was that the only choice we have in dealing with these facts is to become market timers or a sector rotators, which are antithetical to index investing. I can't disagree and you have put your finger squarely on my current dilemma. I fear that the period going forward is going to test the faith of us index investors like it has never been tested before.

I'm trying to decide if my faith is strong enough to last when it begins to look like my retirement assets will expire before I do. Maybe I should just put all my shekels in a money market fund now and let it go at that. Peter Lynch once said that if you're going to make mistakes with your investments, you should make them early. Let us all pray together, brethren.

If it's true that over any 10 year period, equities always outperform bonds, then why should I invest at all in bonds for my retirement portfolio, given that I still have 20 years or more of the daily grindstone?

Bonds might reduce my risk year to year, but if I have a truly long range view (10+ years) and don't mind the occasional downturn, why not take that money and put it into equities? I suggest skipping part four until I'm closer to retirement.

Am I missing something?

Jeff

Could you please recommend an ETF to replace the Fidelity Spartan International Total Market recommendation. Also, is there a reason you recommended a mutual fund in this sector vs. an ETF. Yesterday, I liquidated my two managed accounts (2% per year) and look forward to the wire transfer to begin purchase of your 10 sector index recommendation. Thank you for helping me see the forest from all those trees. bullet

Following your column on building a portfolio, I tried to buy 100 shares of iShares TIP. Fidelity cancelled the attempted buy with a message to the effect that this is a protected security. I intend to phone them for a more enlightening answer but I would like to know from you where I go to add this to my portfolio. Thanks, -- Bob

From Scott Burns:

I've never encountered that. I have accounts at Fidelity--- my own and some accounts I manage for friends--- and I've purchased TIPS in all of the tax deferred accounts with no difficulty at a commission price as low as $8 in the large accounts. These are Fidelity brokerage accounts which contain Fidelity mutual funds, outside mutual funds, individual stocks, and ETFs.

I read your column regularly and learn from it always. Your 2/12/07 article recommending a 10 block portfolio recommended various exchange traded funds. I don't know what an etf is, but since you recommended it, I assume it's legitimate. But you say "use a few index mutual funds instead of ETFs, and your costs could be much lower." Why recommend ETFs if they cost more?

Thanks for your always pertinent, interesting, and well written columns.

Regards, Murry

From Scott Burns:

ETFs can cost more, or less, than the comparable index mutual fund when you measure the expense ratio. The difference is that you will always have to pay a brokerage commission when you buy or sell shares of an ETF. Depending on where your account is, you may not have to pay a commission for shares of an index mutual fund. Let me give you some examples.

If you have an account at Vanguard, a fund firm that offers a wide variety of index funds, you can put together most of the building block portfolios using their index funds and the transaction will be commission free. But suppose your account is at Fidelity? They offer only two major index funds. Whether you use an ETF or a low cost index fund from Vanguard, you will pay a commission to purchase. And the commission to purchase the mutual fund will be significantly larger than the commission to purchase the ETF because the ETF is treated as a common stock. Remember, the ONLY reason there are mutual fund "supermarkets"--- such as the selections available at firms like Vanguard, Fidelity, Schwab, TDAmeritrade, etc. is that the mutual fund company pays the supermarket to be included. That cost is passed on to the investor, usually in the form of a 12b-1 fee.

Basically, you have to examine your particular investment company to see what the least expensive path is. As a practical matter, the larger the portfolio, the greater the odds that concern about commission costs will disappear. You can test this for yourself by using the online ETF portfolio cost calculator on my website. It measures costs as a percent of portfolio assets.

Mr. Burns, allow me to respond to BillE's and your retorts. You tell me I'm taking a cheap shot for pointing out the obvious. You ask me what the S&P has underperformed. The answer is that the S&P has underperformed in the last 5 years that very same average that you originally referred to when making your claim of it's benefits. It's extremely easy to go back after the fact and point out that had you added an international index or emerging market, or small cap ETF to the portfolio it would have well outperformed your averages, but unfortunately, the public doesn't get a do over. For years you stressed the ease of merely taking two funds, splitting them in half and voila', you've finished your financial strategy for the year. However, the truth, which you're now coming forward with, is that by selecting six, eight, or ten indices over the years, you would have been far better off. As to your quote from John Brennan at Vanguard, should we really be surprised that he would laud the value of using his funds as a complete investment strategy? How selective that he chose from 1992 to 2005(?) as his timeline. As to BillE, thank you for making my point. Investing is not so easy. If I'm going to make the effort to shop the newspaper for the best deal of my next oil change, I surely can make that same effort when finding investments for my financial future.

I looked at your asset allocation breakdown and I didn't see government bond funds.

Here is what I do in my 403-b via Vanguard

33% International Growth

33% Total Stock Market

33% split evenly between Vanguard Ginny Mae and Inflation Protected Securities funds

I figure 10 yr until retirement----I have a nagging suspicion I am paying too much for funds that are doing well right now.

Do you think there is a roll for building up govt bond funds as well as stocks?

From Scott Burns:

The Margarita portfolio has a 33 percent allocation to TIPS, Treasury Inflation Protected Securities. The other building block portfolios also have an allocation to this asset class.

Scott: I'm trying to do comparisons between the ten speed and the 12 block recommended by Asset Builder. I've tried to locate the ticker symbols for the recommended funds and ETFs for ten speed, but can't seem to identify the specific ones you are looking at. here's what I have so far Vanguard Total Market Index Fund/ETF = VTI; Treasury Inflation Protected Securities, ishares TIPS = TIP; International total market, Fidelity Spartan International Market = FSIIX; International bonds, such as American Century International Bond = BEGBX; REITs, such as the Vanguard REIT ETF = VNQ; Energy, such as the Vanguard Energy ETF = VDE;; Large US value stocks, ishares russell 1000 value etf = IWD; Small US value stocks, ishares russell 2000 value ETF = IWN; emerging markets, Vanguard Emerging Markets = VWO; International Value Stocks, ishares international value ETF (could not find on Morningstar).????

Any clues?

Thanks for your help, Mary Anne

From Scott Burns:

If you think about each block as an asset class, the portfolios can be built with a fair amount of substitution. Here, for instance, is how it could be done at Vanguard with emphasis on their mutual funds:

Vanguard as fund custodian
Block	Asset Class	Fund Name	Ticker	Exp. Ratio	Min Invest	ETF TKR
1	Domestic Total Market	Vanguard Total Market Index	VTSMX	0.19%	$3,000	VTI
2	TIPS	Vanguard Inflation Protected Securities (m)	VIPSX	0.20%	$3,000	none
3	International Total Market	Vanguard Total International Market	VGTSX	0.31%	$3,000	none
4	International Bonds	American Century International Bond (m)	BEGBX	0.82%	$2,500	na
5	REITs	Vanguard REIT	VGSIX	0.21%	$3,000	VNQ
6	Energy	Vanguard Energy (m)	VGENX	0.28%	$3,000	VDE
7	Domestic Large Value	Vanguard Value	VIVAX	0.21%	$3,000	VTV
8	Domestic Small Value	Vanguard Small Cap Value	VISVX	0.23%	$3,000	VBR
9	Emerging Markets	Vanguard Emerging Markets	VEIEX	0.42%	$3,000	VWO
10	International Value	Vanguard International Value (m)	VTRIX	0.44%	$3,000	na
(m) indicates a managed fund

As you can see, you can do 9 of the 10 blocks with a Vanguard mutual fund. But you can also substitute their ETF funds in many instances (6 of 10), as indicated by the last column to the right.

You can do much the same with a Fidelity account, as indicated below:

Fidelity as custodian
Block	Asset Class	Fund Name	Ticker	Exp ratio	Min Invest
1	Domestic Total Market	Fidelity Spartan Total Market Index	FSTMX	0.09%	$10,000
2	TIPS	Fidelity Inflation Protected Securities (m)	FINPX	0.45%	$2,500
3	International Total Market	Fidelity Spartan Total International Market Index	FSIIX	0.10%	$10,000
4	International Bonds	American Century International Bond (m)	BEGBX	0.82%	$2,500
5	REITs	Vanguard REIT (etf)	VNQ	0.12%	$0
6	Energy	Vanguard Energy (etf)	VTE	0.26%	$0
7	Domestic Large Value	Vanguard Value (etf)	VTV	0.11%	$0
8	Domestic Small Value	Vanguard Small Cap Value (etf)	VBR	0.12%	$0
9	Emerging Markets	Vanguard Emerging Markets (etf)	VWO	0.30%	$0
10	International Value	iShares MSCI EAFE Value (etf)	EFV	0.40%	$0
(m) indicates a managed fund

Because Fido has limited index fund choices, more blocks will have to come from the ETF universe.

It would also be possible to do nearly the entire portfolio with ETFs and still have some freedom of substitution. The only mutual fund is the Am Century International Bond fund which is expensive and managed. I'm hoping an ETF alterative will be launched this year.

All ETF portfolio (all online brokers)				Source 4: Alternative ETFs
Fund Name	Ticker	Exp. Ratio		Fund Name	Ticker	Exp. Ratio
Vanguard Total Market Index	VTI	0.07%		Powershares RAFI 1000	PRF	0.60%
iShares TIPS	TIPS	0.20%		none	na	na
iShares EAFE	EFA	0.35%		none	na	na
none	na	na		none	na	na
Vanguard REIT	VNQ	0.12%		iShares Cohen & Steers Realty	CLF	0.35%
Vanguard Energy	VDE	0.26%		Powershares FTSE RAFI Energy	PRFE	0.60%
Vanguard Value	VTV	0.11%		Powershares RAFI 1000	PRF	0.60%
Vanguard Small Cap Value	VBR	0.12%		Powershares RAFI 1500	PRFZ	0.60%
Vanguard Emerging Markets	VWO	0.30%		none	na	na
iShares MSCI EAFE Value	EFV	0.40%		Wisdomtree DIEFA	DWM	0.48%

There are several differences between the Building Block portfolios and the AssetBuilder portfolios. First, AssetBuilder uses only academically researched and proven asset classes. It considers energy a sector, not an asset class. AssetBuilder uses relatively short maturity fixed income funds from Dimensional Funds. This reduces volatility. Their funds include short term global funds which are much closer to what I'd like to do than American Century International Bond fund. Finally, the Dimensional Funds are, I believe, the best vehicles to capture the additional returns from the Fama/French factors--- value and small size---because they were specifically CREATED to capture those factors. Here is a past performance comparison of the 10 Speed and Building Block 12 portfolios, along with mutual fund benchmarks. As you can see, BB12 trumps the 10 Speed and both trump the Morningstar category averages. Will that lead continue in the future? I don't know. What I think we can be certain of is that the immediate past was a period of above average returns and below average risk, as measured by standard deviation.

Portfolio	Std. Dev.	1 year	3yrs	5yrs
DFA BB12	8.83	24.05	19.71	18.53
10 Speed CP	8.69	20.54	17.05	15.40
Difference	+.14	+3.51	+2.66	+3.13
Avg. World Allocation fund	8.54	16.50	13.34	12.24
Avg. Moderate Allocation fund	8.05	11.26	8.37	6.30
Source: Morningstar Principia, 12/31/06 data

I hope this information is useful.

Dear Mr. Burns Would you please give me the names, symbols, etc. regarding the missing 2 blocks from the 12 block vs. your ten speed. I am not able to find the 12 block on the web site after reading the Feb 10th article and trying the search window. I am old and stupid with computers (age 60!). Lastly, we miss you here in San Antonio and Robert Pincus from LA sends his best. thank you for your assistance, bullet

Dear Mr. Burns How can I build a couch potatoe portfolio using T. Rowe price mutual funds? Which funds would I use? I have a ten year horizon before retirement. Thank you. Chicoman From Scott Burns: I wouldn't recommend using T. Rowe Price to implement the Couch Potato portfolios. T. Rowe Price is a fine active management shop with relatively low expenses--- but they aren't an index shop. Couch Potato investors believe that, long term, most active managers will fail to beat their index so they save the worry about manager risk and invest in index funds. I've done it for years and am delighted with the results.

Hi Mr. Burns,

For your post 3 posts ago about the 10 funds from Vanguard, you have VGENX as the energy fund w/ a minimum of 3000. However, when I checked on Vanguard.com, it says the minimum was 25000. Did you mistake it for a different fund? I currently have all my mutual funds with Vanguard and would like to hold a energy fund w/ them too, but the 25000 minimum is too much.

Thanks! From Scott Burns: Sorry about that. The best alternative is to use their energy ETF, ticker: VDE. You'll pay a brokerage commission but there is no minimum purchase.

I am a teacher attempting to invest according to your Couch Potato Five Fold plan. Currently I have the following account types and amounts: Vanguard investment ($27,000), Vanguard 403(b) rollover ($12,000), Vanguard Roth ($16,000), American Century Roth ($4,000) American Century Investment ($4,000)

I will not be putting future 403(b) money into Vanguard since I have not been able to set up a 403(b) account with them through my school (reasons that I don't understand and apparently don't have any control over). I may be able to set up a Van Kampen 403(b) account (I recently found out that another co-worker has an account with them). Currently my 403(b) money ($600/month) is divided between two variable annuities. I would like to stop investing in these annuities but need some other alternative. I will not be rolling the annuity money to Vanguard for a few years because the annuity withdrawal charges are too high.

I will be putting money into the investment accounts throughout the year.

My questions are: 1) What accounts should hold which funds? 2) Are there Van Kampen funds that you recommend?

Thanks so much for all you do to help everyone. If it wasn't for you and your articles I would have no invested money accept for the annuities. I can't give you credit (blame?) for the annuities ... those salesmen who appear at school can be mighty convincing. From Scott Burns: I suggest that you visit with the HR department for your school district and get a list of 403(b) vendors. Assuming there is such a list, first check it for non-insurance based mutual fund companies. Then look for a no-load mutual fund company such as Fidelity, T. Rowe Price or American Century. What you need to do is by-pass the handholding advisor, if possible, and the added 1.00 to 1.25 percent in additional annual fees he or she represents. This expense is pure dead weight on your retirement future.

Please stay in touch--- let me know what you learn about what is available in your district.