Exchange Traded Funds (ETFs) are touted for their low expenses. This is true for many traditional ETFs, such as the SPDR (SPY), which tracks the S&P 500 Index and carries an expense ratio of around 0.10%. But some ETFs charge much more. For instance, most single-country ETFs charge more than 0.50%. ETFs that focus on a specific industry will also be close to 0.50%. There are even ETFs that charge 0.95% So, just because it is an ETF does not mean it has a low expense ratio.

Mutual Funds that track similar sectors though also have higher expense ratios. So that, even with these high expense ratios, ETFs usually still have lower expenses than comparable mutual funds. But does this mean that ETF are the cheapest option? The low-expense advantage of ETFs may be a mirage because you must pay commissions to buy and sell ETFs.

If you invest regular sums of money each month, an ETF will cost you much more than would a similar mutual fund. If you are putting $1000 a month away and use Sharebuilder’s $4 commission per trade, that still adds 0.40% of expense. Granted, each year you hold the ETF dilutes this expense but it would take a number of years to make up the small advantage that ETFs have over comparable index funds.

If you plan on trading frequently, any cost advantage would be lost. ETFs do have other advantages for frequent traders, but the expense ratio is not one of them.

But there is one more expense that most don’t consider and is much harder to quantify. Every time you buy or sell an ETF, like stocks, you implicitly pay a hidden fee called the ‘bid-ask spread’. This spread is the difference between the buying (bid) and selling (ask) price of the same ETF. This ’slop’ between the bid and ask price is another profit center for the broker handling the transaction.

SPDRs (SPY) probably have one of the lowest bid-ask spreads because it is so heavily traded and there is a heightened interaction between the specialists, market makers, and arbitrageurs. The average bid-ask spread for the SPDR was reported as 0.09%. Bid-ask spreads for such heavily traded ETFs can be quite small but for others, such as certain emerging market ETFs it can be quite large (e.g., for certain emerging market ETFs). Even a spread of 0.09% adds to your cost factor, making no-load mutual funds look more attractive.

Are there reasons to buy ETFs? Yes! Is it because they are ‘cheaper’ than mutual funds? Probably not.

Will invest 30% in bonds, 40% into U.S. equity funds and 30% into international equity funds

From what I am learning but based primarily on Paul Merriman’s “Ultimate Buy-and-Hold Strategy”, my investment portfolio will be structured to return as much as possible yet keep the risk of a major market drop in check. What follows is my current plans on how I will allocate my investment funds.

Bonds will be 30% of my portfolio. Although I am tempted to put a higher percent in equities, everything I read shows that the return is not significantly lowered by adding the bonds and instead the risk factor (beta) is significantly improved.

According to Merriman’s “Ultimate Buy-and-Hold Strategy - Portfolio 2,” the bond portfolio should be invested in 2 to 5 year maturity bonds.

The equity portion of my portfolio will be divided 40% into U.S. equity funds and 30% into international equity funds. The international exposure not only gives good opportunity but, according to Merriman, there is significant non-correlation between the two markets since they are affected not only by different economies but also by the variation of the currency exchange rate.

Domestic equities will be divided equally between 4 sectors (if that is the right word), large-cap blend, small-cap blend, large-cap value, and small-cap value funds. Growth funds are not specifically represented in the mix but that sector is probably well represented in the blend funds.

International equities are also divided into 4 equally funded sectors, large-cap blend, small-cap value, large-cap value, and emerging markets.

So, here is my breakdown:

• 30% Bonds
  • short-term (2-5 year)
• 40% U.S. Equities
  • 25% large-cap blend
  • 25% small-cap blend
  • 25% small-cap value
  • 25% large-cap value
• 30% International Equities
  • 25% large-cap blend
  • 25% small-cap value
  • 25% large-cap value
  • 25% emerging markets

In the next article I will look at what funds I will use in each investment sector.

I just ran across Morningstar’s Investing Classroom. The site has courses available that will help you build and understand your portfolio. Courses can be audited but if you complete the free registration you get credits that can be exchanged for Morningstar products and merchandise.

The classes are grouped under four topics, Portfolio, Stocks, Mutual Funds, and Bonds. Under each topic there are 100, 200, 300, 400, and 500 level courses, with 10 or so classes in each level. I plan to go through the portfolio classes then the mutual fund classes.

I look forward to being able to take and understand these classes:

• 501: Why Bother with Investment Theory?
• 502: Efficient Market Theory
• 503: Modern Portfolio Theory
• 504: Asset Allocation Is “It”
• 505: Can Foreign Stocks Really Diversify a Portfolio?
• 506: Value: The “Better” Approach?
• 507: Measuring Mutual-Fund Manager Skill
• 508: The Small-Company Advantage: Fact or Fiction?
• 509: The Demise of Dividends
• 510: Behavioral Finance

In Portfolio 4 we looked at dividing the equity portion of our investment between large- and small-cap stocks and between large- and small-cap value stocks. This diversification has improved the historical return of our portfolio to 12.1 percent and only increased volatility slightly.

Merriman’s final step is to include international stocks in our portfolio. Like U.S. stocks, foreign stocks also go up and down, but usually they are not in sync with the fluctuations of the U.S. market. This makes them a “non-correlated” asset, meaning it responds to different external forces and has its own up and down trends that do not match the U.S. market. In other words, when one is going down the other is still going up, so that when the two trends are combined their short-term movements cancel each other out, smoothing out a long-term (hopefully) upward curve.

According to Merriman, there are two reasons international stocks are non-correlated with U.S. stocks. First, and most obvious, the companies are operating in a different world markets, subject to different economic forces. Second, any gain or loss of a stock in that foreign market also has to be ‘translated’ into U.S. dollars at the current exchange rate, which is another ‘non-correlated’ factor in and of itself.

Just as we balanced large-cap stocks with small-cap and value stocks with growth stocks so also it is equally important to diversify our international stock holdings. Portfolio 5, therefore, will add international large-cap growth and value, international small-cap growth and value as well as a some emerging markets stocks which should provide significant growth opportunity.

Although in the article Merriman adds one further tweak to his portfolio, this really is the basis for his Ultimate Buy-and-Hold Strategy in which we attempt to increase our return while reducing our risk. Based on historical data, if in 1970 you had invested $100,000 in this portfolio, it would have grown to nearly $8.5 million.

Merriman has “suggested portfolios” available on this web site depending on where you have your investments. Since mine are at Schwab, I used Schwab’s fund screener to determine the international funds I think I should invest in:

Now that I have a better understanding of Merriman’s Ultimate Buy-and-Hold Strategy, I need to come up with my own investment plan. How am I going to put his advice into practice, especially with my limited capital.

The Four Pillars of Investing : Lessons for Building a Winning Portfolio by William Bernstein is on just about all of the must-read lists I have seen. Dr. Bernstein provides investors the tools they need to successfully build their own portfolios by focusing on the essentials of investment theory, market history, market psychology, and the investment industry.

There is nothing ‘new’ in the book, it preaches the wisdom of using market indexing and asset allocation rather than investing in individual stocks or managed mutual funds that is common to many investment gurus. Novelty, though, has never been a hallmark of successful long term investing. Investing should be boring…if it gets too exciting, you are doing something wrong.

Here is the summary from the back of the book:

… Dr. Bernstein explains how any independent investor can construct a superior investment portfolio by learning these four essentials:

• The Theory of Investing -­ “Do not expect high returns without risks.”
• The History of Investing -­ “About once every generation, the markets go barking mad. If you are unprepared, you are sure to fail.”
• The Psychology of Investing -­ “Identify the era’s conventional wisdom and assume that it is wrong. More often than not, it is.”
• The Business of Investing -­ “The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks.”

And the inside jacket blurb has this great statement:

Investing is not a destination. It is a journey, lined with stockbrokers, journalists, and mutual fund companies whose interests are diametrically opposed to yours. The Four Pillars of Investing shows you how, with relatively little effort, you can determine your own financial direction and assemble an investment program with the sole goal of building long-term wealth for yourself and your family.

MyMoneyBlog has a very good idea about setting up a “firewall” checking account to protect your regular account from getting drained if somehow the bank account you use for things like PayPal gets compromised.

If you set up a separate bank account that you put money in when you are buying something and take it out after you have sold something then the worse that can happen is an NSF fee if someone gets your account info. Lots better than loosing $1000+.

Only thing you need is a no-minimum balance bank account. I will suggest ING. If you use one of my kid’s ING referral codes then you will get $25 for opening the account (and one of my kids gets $10). You will probably want to remove the $250 needed to get the $25 after the money has been in there 30 days.

Unless you’ve been under a rock for the last few years, you’ve gotten 124 PayPal phishing e-mails telling you that your account has been suspended, yada yada, gimme your login and password. New variations come out every day. I bet that more people are being fooled than we know of, mostly due to the shame of admitting it.

I just checked out the audio-book Total Money Makeover by Dave Ramsey from the local library. I have never heard Dave Ramsey on the radio but have heard of him from friends and relatives. As a matter of fact I understand my wee grandson likes to blurt out something along the lines of “I am Debt Free” every so often.

As I have been listening to the audio-book and am impressed so far. Of course on the first CD he has not really got into the system yet. He is preparing the listener for the system by telling us how ‘fat and unhealthy’ we are financially and that the world has trained us to be credit stupid. Is he too simplistic? I may have an opinion on that later. But I do believe he is correct that most of us in America are no different than a tantrum-throwing 2-year-old who hollers “I want, I want” - the only difference is there are no parents out there to tell us NO! Instead there are credit companies who happily lend us money.

So far he starts out by debunking a number of credit myths. Here are some of them:

Myth: Lending money to family and friends is a blessing.
Truth: Lending money to family changes the relationship. You now have a master/servant relationship and until the money is paid back there will not be the same.

Myth: By cosigning a loan, I am helping a friend or relative.
Truth: Be ready to repay the loan. The bank wants a cosigner for a reason - they don’t expect the friend or relative to pay.

Myth: Aren’t there positive uses of a credit card? Like rebates and airline miles?
Truth: There is NO positive side to credit card use. You will spend more if you use credit cards cause it hurts to pay cash. So even by paying the bills in full, you are not beating the system! And most families end up not paying in full.

A study by Dun & Bradstreet showed that the credit-card user spends 12 to 18 percent more when using credit instead of cash. It hurts when you spend cash, and therefore you spend less. The big question is, what do millionaires do? They don’t get rich with free hats, brownie points, air miles, and the use of someone else’s money. What do broke people do? They use credit cards.

Myth: Debt is a tool and should be used to help create prosperity.
Truth: Debt isn’t used by wealthy people nearly as much as we are led to believe. (That is how they became wealthy.) If you’re in debt, then you’re a slave, in the sense that you do not have the freedom to use your money as you see fit.

Myth: Debt consolidation saves interest, and you have one smaller payment.
Truth: Debt consolidation is dangerous because you treat only the symptom. You think you’ve done something about the debt problem but the debt is still there, as are the habits that caused it - you just extended it! Many times the payment is lower because the term to pay back the loan is longer - not because the interest is lower.

Myth: Make sure your teenager gets a credit card so he or she will learn to be responsible with money.
Truth: Getting a credit card for your teenager is an excellent way to teach him or her to be financially irresponsible. That’s why teens are now the number-one target of credit card companies.

I will let you know what I learn as I proceed through disk 2.

I finished listening to the 2nd of 3 CDs in the audio-book Total Money Makeover today. On this CD Dave Ramsey gives an overview of the first couple steps in his “Baby Steps” program which is designed to getting your finances under control. He begins by emphasizing the necessity of creating and living by a written budget.

The problem I have is that he really gives no details on how to set up a budget or how to follow one. He definitely tells you that you must have one, he just forgets to tell you how to do it - or at least in this book. I suppose he has another book that teaches this pre-step.

Once the budget is put into action, Ramsey says we need to start taking the “Baby Steps” required to get our finances in order.

The first (or was the budget the first?) step to getting financially fit is to start building an emergency fund of at least $1,000 as quickly as you can. This means paying minimum payments on credit cards and nothing into your retirement plan until this first $1,000 has been set aside. The primary reason this is so important is that otherwise any emergency that comes while paying off your accumulated debt would force you to break stride and most probably put the emergency expense on a credit card.

The second step is to pay off all debt (except the home) as quickly as possible using a process he calls the “debt snowball.” Rather than paying off high interest rate debts first, Ramsey suggests paying debts with the smallest balance first. You pay the minimums on all the other debts and keep them current. Every other dollar you can possibly scrounge is used to pay off your smallest-balance debt. When that debt is gone, you move to the next debt on your list, so that the amount you are able to pay “snowballs” as debts disappear.

“All the money from old debts and all the money you can find anywhere goes on the smallest debt until it is gone,” advises Ramsey. “Every time the Snowball rolls over, it picks up more snow and gets larger, until by the time you get to the bottom, you have an avalanche.”

Ramsey then began discussing step #3, building your emergency fund up to at least three months of living expenses. Paying off your credit cards and loans is about getting yourself out of debt now, building your emergency fund is about staying out of debt forever.

“You start the emergency fund with $1,000, but a fully-funded emergency fund will usually range from $5,000 to $25,000. The typical family that can make it on $3,000 per month might have a $10,000 emergency fund as a minimum. What would it feel like to have no payments but the house, and $10,000 in savings for when it rains?

And it will rain… The emergency fund, Ramsey says, is not to be used to pay for things like Christmas (“Christmas is NOT an emergency!”) and clothing. You should have budgeted for these predictable items in advance. (He just doesn’t go into how this might be done.)

Well, I have one more CD to listen to on this audio-book. So far it seems that the information given is from the 10,000 foot level - great view but no detail. I want to have someone answer the nuts and bolt questions. Hopefully this product is not simply an infomercial for his other products.