In July a reader asked if I ate my own cooking. He wanted to know if I used a financial advisor. He also wanted to know if 75 percent, or more, of my money was invested in index funds.

I wrote that I didn't use an advisor and that my taxable, SEP-IRA, and IRA accounts were 72, 100, and 85 percent index funds, respectively, but that my 401(k) account was only 20 percent index funds.

Why? Only one of the 17 funds in my employers' plan was an index fund. "I am about to correct that," I wrote, "by using a new self-directed brokerage option."

I did not do this with great enthusiasm.

For one thing, there is an annual charge of $100. More important, the idea of turning a 401(k) account into a trading vehicle has always struck me as dumb. The purpose of 401(k) accounts is to create a long-term vehicle for the accumulation of retirement money. Trading stocks defeats the purpose. It would also raise costs, the archenemy of compound accumulation.

In fact, if your account is large enough, you can use a brokerage account window to reduce fund costs. You can also eliminate "manager risk"--- the worry that your chosen fund will be a turkey. In addition, by moving to broad index funds you may also reduce the less visible costs of portfolio turnover. Basically, you can get out of the 'Manager of the Month' game.

"If your account is large enough" is an important caveat. If your account is less than $50,000, you can stop reading now. The $100 annual fee will add 0.2 percent a year (or more) to the annual cost of managing your money. The commission on each trade will add still more cost. But if your account is north of $100,000 or $200,000, read on.

There are two reasons I've been slow to do this. First, my employer didn't offer the brokerage window option until very recently. Second, Fidelity is a terrific shop. Their funds tend to have above average performance and below average expenses.  I've enjoyed long periods of superior returns by investing in Magellan, Puritan, Growth and Income, and (in the last three years) Dividend Growth. The overall cost of managing the money has been a bit less than 1 percent a year. That's far less than millions of 401(k) and 403(b) investors pay for the investment options in their plans.

Magellan, however, has trailed the S&P 500 index so far this year and in six of the preceding 10 years. So have a number of Fido's other lead funds. Trading manager risk for the certainty of lower costs looks better as you get older. A move to index funds could reduce costs to about 0.20 percent a year, excluding commissions. That's a material cost reduction.  The question is how to do it.

Here are four paths:

  • Use No Transaction Cost Funds. This is convenient but it doesn't work very well. Basically, it will expand your choices but it won't reduce your costs. Virtually all of the no-transaction cost funds expenses are at least as high as Fidelity's managed funds. It also won't get you out of the pick-a-winning-manager game.

  • Use Fidelity Spartan Index Funds.  As I've pointed out in other columns,Fidelity has a limited menu of index funds---only 6. With no commission costs you could invest in their S&P 500 index fund (0.19 percent expense ratio), their Extended Market Index fund (0.25 percent expense ratio),and their International Index fund, which duplicates the broad EAFE index (0.35 percent). Basically, it will cost you $100 a year to become a Fidelity index investor, though you'll have to be in managed funds for fixed income.

  • Pay Commissions To Buy Funds.  This works best with large accounts because the minimum commission for an online mutual fund purchase is $75. Fidelity Spartan Total Stock Market Index has an annual expense ratio of 0.25 percent, a minimum purchase of $15,000, and no commission.  Vanguard Total Stock Market Index, on the other hand, has an annual expense ratio of 0.20 percent. That means you'll have to invest over $150,000 before the $75 commission and 0.05 percent annual difference in expenses will cost less in the first year than the comparable Fido fund.

  • Pay Brokerage Commissions To Buy Exchange Traded Index Funds. Since exchange traded index funds--- and there are over 100 today, with more coming--- trade like common stocks, your commission cost will depend on whether Fidelity ranks you as a "bronze", "silver",or "gold",customer. If your account is valued at $100,000 or more, you'll qualify for "silver" and transactions will cost about $14.95. Shares of iShares Russell 3000 Index (very close to Total Market) have an expense ratio of 0.20 percent, so you'll break-even compared to the Fido fund on a transaction valued at $29,900.  Buy the iShares S&P 500 Index fund with an expense ratio of 0.09 percent compared to the Fidelity Spartan Equity Index (expense ratio 0.19) and the break-even transaction will be less, $14,950.



Keeping the bulk of my 401k assets in exchange-traded-index funds is the route I've taken. Today, there is only a handful of fixed income ETFs. An Inflation Protected Treasury ETF and a Total U.S. Bond Market ETF are on the way.