by Archie M. Richards, Jr., CFP^®
September 13, 2004

Al, who read my book "All About Exchange-Traded Funds," notes that I recommend the following four funds for the 30-percent share of a portfolio I suggest allocating to U.S. stocks:

• 10 percent iShares Russell 1000 Growth Index Fund (big growth stocks)
• 10 percent iShares Russell 1000 Value Index Fund (big value stocks)
• 5 percent iShares Russell 2000 Growth Index Fund (small growth stocks)
• 5 percent iShares Russell 2000 Value Index Fund (small value stocks)

(For the portfolio's remaining 70-percent share, I recommend in my book ETFs of foreign stocks, REITs, and bonds.)

Al asks, "Instead of splitting the money among four funds for the U.S. portion of the portfolio, why not use the iShares Russell 3000 Index Fund instead?

Before answering the question, here's an explanation of terms:

Exchange-traded funds (ETFs) are similar to mutual funds, except that they may be bought and sold throughout the trading day, not just after the close. I suggest using ETFs, however, to buy and hold.

Each purchase or sale of an exchange-traded fund requires payment of a commission. Therefore, omit ETFs for small investments. Buy no-load index mutual funds instead.

iShares is the trade name for exchange-traded funds operated by Barclays Global Investors, of San Francisco, California.

Russell stands for the Russell Investment Company, of Tacoma, Washington. The company has designed market indexes, which are hypothetical portfolios that measure the performance of a particular category or sector of stocks. The largest Russell index, the Russell 3000 Index, consists of the 3,000 largest publicly-held U.S. stocks. The Index includes stocks representing 98 percent of the market value of all publicly-held U.S. stocks.

The Russell 1000 is an index of the 1,000 largest publicly-held U.S. stocks, representing 92 percent of the value of the Russell 3000 stocks.

The Russell 2000 is an index of the 2,000 smallest publicly-held U.S. stocks, representing 8 percent of the value of the Russell 3000 stocks.

The Russell Company divides both the 1000 and the 2000 indexes into growth and value portions, making separate indexes for each. These are the four index funds I recommend above. Growth stocks have high market values in relation to the company earnings. Value stocks have low market values in relation to earnings.

Once a year, Russell reconstitutes its indexes. Let's say the market value of a company is large enough to include it in the 3000 Index. But in the following year, the company's market value falls, making the stock too small. Russell removes the company from the 3000 index, substituting another whose market value qualifies.

While indexes are hypothetical portfolios, exchange-traded funds are real portfolios. The iShares Russell 3000 Index Fund, for example, actually holds 3,000 stocks. Since the fund owns the stocks chosen by the Russell Company for its index, no stock research is needed. Except for modest fees, the fund generally follows the index. Avoiding stock research cuts costs.

Since the indexes are reconstituted only once a year, the portfolio of the corresponding ETFs requires little trading. Exchange-traded funds are traded frequently, but the stocks held within ETF portfolios are not. This cuts costs as well.

I suggest rebalancing a portfolio annually when any sector moves more than 30 percent. During the year, for example, if the 1000 Growth Fund changes from 10 percent to 13.1 percent of the portfolio, I recommend selling 3.1 percent to bring the sector back to 10 percent, investing the proceeds in other weaker sectors.

Let's return now to Al's question: Why not use the Russell 3000 Index Fund alone instead of the four funds I suggest?

If your amount of money is limited, Al, the iShares Russell 3000 is fine. Otherwise, use the four funds. Here's why:

• In the long run, small stocks gain more than big ones. The allocation I give to small stocks is greater than would apply if you acquired just the Russell 3000 Index Fund.

• The rebalancing I suggest has greater effect than the annual reconstitution of the Russell 3000 Index.

Exchange-traded funds are great for constructing a portfolio. To reduce risk, allocate to many sectors, with annual rebalancing. Beyond this, just continue holding for years.