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Scott Burns / Syndicated columnist
Exchange-traded funds a good fit for portfolio

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One bag contains only one club and is labeled "stock." The other contains the full complement of drivers and putters and is labeled "ETF," for exchange-traded fund.

Ameritrade is telling us that you can play a better investing game with a diversified bag than with a single-stock bag.

Their suggestions don't stop there.

In a lengthy message titled "Managing Estate Planning With ETFs," the brokerage firm suggests, "If you have accumulated significant assets in your retirement accounts, you can roll them into a 'stretch IRA' that allows you to extend withdrawals over several generations." (You can do this by naming a child or grandchild as a contingent beneficiary of the account. This will allow your surviving spouse to calculate withdrawals based on the longer combined life expectancy of spouse and the much younger child/grandchild. Result: Your IRA money can grow tax-deferred, with modest distributions, for generations rather than years.)

What investments do they suggest for what should be called your Personal Dynasty Account?

You guessed it: low-cost, low-turnover exchange-traded funds. ETFs are open-end index funds that trade like common stocks. Currently, there are 126 ETFs. They track a variety of indexes for the domestic stock market, including specific sectors such as energy, health care and technology. Other ETFs track groups of markets.

Invest in one of the broader indexes, such as the Vanguard Total Stock Market VIPERS (ticker: VTI), and you'll own the entire U.S. stock market at an annual expense of 0.15 percent. Indeed, the original SPDRs Trust (ticker: SPY) invests in S&P 500 index stocks and has an expense ratio of only 0.12 percent. Its new competitor, the iShares S&P 500 fund (ticker: IVV), has an expense ratio of only 0.09 percent.

We're talking cheap, really cheap.

Ameritrade concludes, "Over time ... the low management fees that make ETFs so efficient will make their performance far superior to that of a comparable, but more expensive mutual fund."

But let's take the whole question a little further.
 
According to the Morningstar mutual-fund database, the average tenure for a domestic-equity-fund manager is 4.6 years. It's the same for international equity funds. It's 5.2 years for taxable bond funds. If you are investing with your dynastic children in mind, you're thinking about 50 years.

So ponder. If portfolio managers change every five years or so, someone will be trying to make 10 good manager guesses to achieve superior performance over the next 50 years.

What are the odds that someone will do better than a broad index mutual fund or ETF?

Here's the math. Abundant research and history show that a broad index fund is likely to do better than about 70 percent of its more expensive managed competitors. At this moment, for instance, the Vanguard Total Market fund has done better than 69 percent of the competition over the last five years, and that's its worst performance figure. The 10-year figure is better than 71 percent of its competitors; the three-year figure is better than 84 percent of its competitors.

So your as-yet-unnamed-expert has about a 30 percent chance of better performance with the first selection. At the second selection, the chance drops to 9 percent (30 percent times 30 percent). By the third selection, the probability is down to 2.7 percent, and so on. Basically, the 50-year probability is zip, and that's assuming your fund selector doesn't charge an annual- percent-of-assets fee for his brilliance. Add a 1 percentage point annual fee, and your dynastic money is dead meat.

If you think long term, index investing is the way to go. Exchange-traded funds, like traditional index mutual funds, can help us do it.

Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at scott@scottburns.com. Questions of general interest will be answered in future columns.