ETFs

ETFs vs. Index Funds (revisited)

For investors who have only recently decided to switch their portfolio to low-cost, indexed investments, one of the questions that must be answered is whether to use ETFs or traditional index funds. We discussed this issue a couple of years ago here on the blog, but many things have changed since then.

Comparing Expenses

Two years ago, arguably the biggest factors in the decision were that ETFs had lower expense ratios than most index funds, but you had to pay a commission to purchase them. Since then, however, multiple brokerage firms (most notably, Vanguard, Fidelity, Schwab, and TD Ameritrade) have begun to allow for commission-free trades of certain low-cost ETFs.

On the other hand, ETFs no longer offer much (if anything) in the way of savings with regard to expense ratios. If you have $10,000 or more to invest in a given fund, you can have access to the “Admiral shares” version of most Vanguard funds, which usually have expense ratios as low as the lowest-cost ETFs. (Prior to October 2010, the Admiral shares had a minimum initial investment of $100,000 rather than $10,000.)

In short, when it comes to expenses, there is no longer a significant difference between the lowest-cost ETFs and the lowest-cost index funds.

Tax-Efficiency

Much has been written about the difference in tax-efficiency between ETFs and traditional index funds. Some people argue that ETFs have lower tax costs, while others argue exactly the opposite. As far as I can tell from comparing Morningstar’s “tax cost ratios” for several index funds and comparable ETFs, it’s not entirely clear which side of the argument is correct.

What is clear though is that both index funds and passively managed ETFs are far more tax-efficient than the majority of their actively managed counterparts — primarily due to the fact that passively managed funds have much lower portfolio turnover than actively managed funds.

More Important Considerations

For most investors, because of the industry changes in recent years, the ETF vs. index fund decision now comes down to considerations other than costs.

It makes sense to use ETFs if you care about:

Buying or selling your holdings in the middle of the day, or
Using types of orders other than market orders (limit orders, for instance).

Conversely, it makes sense to use traditional index funds if you care about:

Being able to buy fractional shares, or
Setting up automatic purchases (or sales) at regular intervals.

Personally, I don’t particularly value the advantages offered by ETFs, so I choose to use traditional index funds. For other investors, ETFs will be a better fit.

In any case, for investors using a “buy, hold, and rebalance” strategy, the differences between low-cost ETFs and low-cost index funds are slim. Your long-term success is unlikely to be affected either way as a result of the decision.

October 17, 2011 5 comments

Are ETFs Bad for Investors?

From time to time I see financial writers lamenting the explosion in ETF popularity over the last few years. They complain that the original idea of index investing (i.e., buying and holding a low-cost, diversified portfolio) has been perverted in favor of a focus on trading ETFs for short-term profits.

Frankly, I disagree. I think the proliferation of ETFs has, on the whole, been great for investors.

(Quick note: I’m not arguing that ETFs are better than the index funds that already existed. Nor am I saying that most investors should be buying ETFs on margin, day trading them, or buying sector-specific ETFs.)

More Access to Low-Cost Investments

A couple decades ago, pretty much the only way to build an indexed portfolio was to have an account at Vanguard. Today, anybody with a discount brokerage account has access to the tools with which to put together a low-cost, diversified portfolio.

Is that bad for investors?

Price Competition

Over the last year or so:

Schwab created their own commission-free ETFs,
Fidelity responded by working out a deal with iShares to offer commission free trades on iShares ETFs, and
Vanguard eventually replied by allowing for commission-free trades of Vanguard ETFs.

It’s price competition in action, and I doubt it would have happened if it weren’t for the massive demand for ETFs.

Is that bad for investors?

Cost Awareness

We’re naturally cost-conscious in most areas of their lives. We do our best to save money on groceries, utility bills, back to school supplies — everything. Everything, that is, except for investments.

For decades, investors have been paying through the nose for mutual fund portfolios. And we’ve been doing it without even realizing it.

That’s finally changing. More and more investors are becoming cost-conscious about their portfolios. And ETFs are (at least in part) to thank for that.

For example, when Fidelity and Schwab each promoted their commission-free ETFs, they promoted the low-cost aspect of it. There were full-page adds in financial magazines encouraging investors to pay attention to expense ratios and commissions per trade.

Is that really so bad?

June 21, 2010 5 comments

How to Choose ETFs for Your Portfolio

A reader recently asked me how to choose between ETFs when creating a low-cost ETF portfolio.

The first step, of course, is to choose the asset allocation that you want. But what then? For example, any of the following ETFs could satisfy the large-cap U.S. equity portion of your portfolio:

Vanguard Large Cap ETF (VV)
Vanguard S&P 500 ETF (VOO)
iShares S&P 500 Index (IVV)
SPDR S&P 500 (SPY)
Schwab U.S. Large-Cap ETF (SCHX)

How should you choose between them?

Expense Ratio

Without a doubt, the first thing I’d check is the expense ratio. As we know, minimizing expenses improves investment results.

Vanguard Large Cap ETF (VV) Expense ratio: 0.12%
Vanguard S&P 500 ETF (VOO) Expense ratio: 0.06%
iShares S&P 500 Index (IVV) Expense ratio: 0.09%
SPDR S&P 500 (SPY) Expense ratio: 0.09%
Schwab U.S. Large-Cap ETF (SCHX) Expense ratio: 0.08%

Winner: Vanguard S&P 500 ETF, but not by much.

Small Bid/Ask Spread

After checking expense ratios, I’d look for a small bid/ask spread. When buying or selling an ETF (or any stock) the bid/ask spread acts as a cost to investors. You have to buy at the (higher) “ask” price, but you can only sell at the (lower) “bid” price. As of 4/27/2011, the spreads were as follows:

Vanguard Large Cap ETF (VV) Spread: 0.016% of ask price
Vanguard S&P 500 ETF (VOO) Spread: 0.016% of ask price
iShares S&P 500 Index (IVV) Spread: 0.007% of ask price
SPDR S&P 500 (SPY) Spread: 0.007% of ask price
Schwab U.S. Large-Cap ETF (SCHX) Spread: 0.021% of ask price

Winner: iShares S&P 500 or SPDR S&P 500. But again, the difference here is extremely small.

Which index does it track?

It’s important to check that the ETF tracks an index with an allocation you desire. In the case of the US large-cap indexes in question, there’s not much of a difference. For example, the following chart shows the performance of an S&P 500 index fund as compared to the Vanguard Large-Cap Index Fund.

Conclusion: The two indexes aren’t just closely related. They’re functionally the same.

When looking at other asset classes, however, this becomes a more important question. For example, in the international stock category, it’s important to check whether the index being tracked includes exposure to emerging markets.

After eliminating any ETFs that track indexes that don’t fit into your target allocation, I’d also suggest eliminating any ETFs tracking indexes that have particularly high turnover (because turnover leads to increased, unreported expenses).

Vanguard Large Cap ETF (VV) Portfolio turnover: 8%
Vanguard S&P 500 ETF (VOO) Portfolio turnover: 5%
iShares S&P 500 Index (IVV) Portfolio turnover: 7%
SPDR S&P 500 (SPY) Portfolio turnover: 5.38%
Schwab U.S. Large-Cap ETF (SCHX) Portfolio turnover: 3%

Winner: Schwab U.S. Large-Cap ETF. Again, a very small difference.

Conclusion: Take Your Pick.

In this particular case, I’d be happy investing in any of the five ETFs asked about. That said, by analyzing expense ratios, bid/ask spreads, and differences in indexes, I can see that there are several U.S. large-cap ETFs I wouldn’t want to invest in. For example, I’d stay away from iShares KLD Select Social Index with its 0.50% expense ratio and 37% annual portfolio turnover.

January 18, 2010 10 comments

ETF List: The Best (Low-Cost) ETFs

Quick note: This article focuses on ETFs from the perspective of a buy & hold investor. If you’re looking for information for more active investors, I’d suggest signing up for a Morningstar account. (It’s free.)

Last week’s post on the best/lowest-cost index funds went company-by-company. One of the nice things about ETFs is that all you need is a discount brokerage account somewhere, and you can pick and choose between ETF providers–no need to stick with just one company.

In that vein, this week’s comparison of ETFs is sorted by asset class rather than by company. Really, it’s just a shopping list of sorts: The lowest-cost ETFs that I’ve found for each asset class. If you know of others that should be added (or any that should be replaced with something else), please feel free to share.

Update: Because of the fact that Vanguard now allows investors to trade Vanguard ETFs with no commissions in a Vanguard brokerage account, I’ve used Vanguard ETFs wherever possible. (In most cases, they have the lowest expense ratios as well.)

Domestic Stock ETFs

Asset Class	Name	Ticker	ER
Total Stock Market	Vanguard Total Stock Market ETF	VTI	0.07%
Large-Cap Blend	Vanguard S&P 500 Index ETF	VOO	0.06%
Large-Cap Value	Vanguard Value ETF	VTV	0.14%
Large-Cap Growth	Vanguard Growth ETF	VUG	0.14%
Small-Cap Blend	Vanguard Small-Cap ETF	VB	0.14%
Small-Cap Value	Vanguard Small-Cap Value ETF	VBR	0.14%
Small-Cap Growth	Vanguard Small-Cap Growth ETF	VBK	0.14%

International Stock ETFs

Asset Class	Name	Ticker	ER
Developed Markets:
Large-Cap Blend	Vanguard Europe Pacific ETF	VEA	0.15%
Large-Cap Value	iShares MSCI EAFE Value Index	EFV	0.40%
Mid-Cap Value	WisdomTree Interntnl SmallCap Div	DLS	0.58%
Emerging Markets:
Large-Cap Blend	Vanguard Emrg Mkts ETF	VWO	0.27%
Emrg & Devlpd Markets:
Large-Cap Blend	Vngrd FTSE All-World Ex-U.S. ETF	VEU	0.25%
Mid-Cap Blend	Vngrd FTSE AW ex-US Sm-Cap ETF	VSS	0.40%

Bond ETFs

Asset Class	Name	Ticker	ER
Short-Term Bond	Vanguard Short-Term Bond ETF	BSV	0.12%
Interm-Term Bond	Vanguard Total Bond Market ETF	BND	0.12%
Interm-Term Gov’t	Vanguard Inter-Term Gov’t Bond ETF	VGIT	0.15%
Long-Term Gov’t	Vanguard Long-Term Gov’t Bond ETF	VGLT	0.15%
Long-Term Bond	Vanguard Long-Term Bond ETF	BLV	0.12%
TIPS	iShares Barclays TIPS Bond	TIP	0.20%

Alternative Asset Class ETFs

Asset Class	Name	Ticker	ER
REITs	Vanguard REIT ETF	VNQ	0.13%
Precious Metals (Gold)	SPDR Gold Trust ETF	GLD	0.40%

Too Much of a Good Thing

In my opinion, that very same flexibility–the ability to buy 800 different ETFs from one discount brokerage account–is also the danger of ETF investing. It’s easy to get carried away tinkering with your portfolio, when the reality is that most of us would be better served by simply buying a handful of ETFs and holding them as long as we can.

October 20, 2009 12 comments

8 Lazy ETF Portfolios

I’m a firm believer that investing doesn’t have to be complicated and that it doesn’t have to require a great deal of ongoing effort. In that vein, I’m always drawn to “lazy portfolios.” The following are ETF renditions of some of the most popular lazy portfolios.

Most of them could be done just as well using regular Vanguard index funds. The ETF versions simply allow you to implement the portfolios at your brokerage firm of choice. (See here for more about ETFs as compared to index funds.)

1. Allan Roth’s Second Grader Portfolio

60% Vanguard Total Stock Market ETF (VTI)
30% Vanguard Total International Stock ETF (VXUS)
10% Vanguard Total Bond Market ETF (BND)

The asset allocation between the funds is clearly intended for a younger, more aggressive investor. But Roth’s idea of keeping it simple applies to everyone. Even for investors close to (or in) retirement, these three ETFs should get the job done.

2. David Swenson’s Ivy League Portfolio

30% Vanguard Total Stock Market ETF (VTI)
5% Vanguard Emerging Mkts ETF (VWO)
15% Vanguard Europe Pacific ETF (VEA)
20% Vanguard REIT ETF (VNQ)
15% Vanguard Intermediate-Term Government Bond ETF (VGIT)
15% iShares Barclays TIPS Bond (TIP)

David Swenson, the Chief Investment Officer at Yale University, recommends the above portfolio (a 70/30 stock/bond allocation) in his Unconventional Success. He is a big proponent of equity-oriented allocations for investors with long time horizons.

3. Rick Ferri’s Core Four Portfolio

36% Vanguard Total Stock Market ETF (VTI)
18% Vanguard Total International Stock ETF (VXUS)
6% Vanguard REIT ETF (VNQ)
40% Vanguard Total Bond Market ETF (BND)

“You only need a few asset classes in your portfolio, and after that there are diminishing returns. The mutual funds you choose to represent those asset classes should be the lowest cost funds you can buy.” –Rick Ferri, CFA on the Bogleheads Forum

4. Bill Schultheis’ Coffeehouse Portfolio

10% Vanguard S&P 500 Index ETF (VOO)
10% Vanguard Value ETF (VTV)
10% Vanguard Small-Cap ETF (VB)
10% Vanguard Small-Cap Value ETF (VBR)
10% Vanguard Total International Stock ETF (VXUS)
10% Vanguard REIT ETF (VNQ)
40% Vanguard Total Bond Market ETF (BND)

The title of Bill’s book, “The New Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, and Get on with Your Life” is spot on. The above portfolio is intended to be rebalanced once per year and otherwise left alone. Sounds good to me.

5. Larry Swedroe’s Big Rocks Portfolio

9% Vanguard S&P 500 Index ETF (VOO)
9% Vanguard Value ETF (VTV)
9% Vanguard Small-Cap ETF (VB)
9% Vanguard Small-Cap Value ETF (VBR)
6% Vanguard REIT ETF (VNQ)
3% Vanguard Total International Stock ETF (VXUS)
6% SPDR S&P International Dividend (DWX)
3% Vanguard FTSE AW ex-US Sm-Cap ETF (VSS)
3% WisdomTree International SmallCap Div (DLS)
3% Vanguard Emerging Mkts ETF (VWO)
40% Vanguard Short-Term Bond ETF (BSV)

You’ll note that Swedroe’s portfolio is significantly tilted toward small-cap and value equities (with the reasoning that their higher risk levels should bring higher expected returns). It’s more funds than I’d personally like, but Swedroe makes a valid point that if you’re only rebalancing annually, the additional effort required by having a few more funds in your portfolio is pretty minor.

6. Harry Browne’s Permanent Portfolio

25% Vanguard S&P 500 Index ETF (VOO)
25% Vanguard Long-Term Government Bond ETF (VGLT)
25% Cash (i.e., money market funds)
25% SPDR Gold Trust ETF (GLD)

The idea behind Browne’s Permanent Portfolio is that the four asset classes have sufficiently low correlation that the portfolio should be able to put up modest gains each year under just about any circumstance imaginable.

7. William Bernstein’s No Brainer Portfolio

25% Vanguard S&P 500 Index ETF (VOO)
25% Vanguard Small-Cap ETF (VB)
25% Vanguard Total International Stock ETF (VXUS)
25% Vanguard Total Bond Market ETF (BND)

Bernstein, author of The Four Pillars of Investing, suggests the above portfolio for investors with a long time horizon. Note that it’s very similar to the first portfolio mentioned above (Roth’s Second Grader Portfolio), but with a much heavier allocation toward small-cap domestic stocks.

8. Harry Markowitz’s “Father of Modern Portfolio Theory” Portfolio

50% Vanguard Total World Stock ETF (VT)
50% Vanguard Total Bond Market ETF (BND)

Harry Markowitz–Nobel Prize winner and originator of Modern Portfolio Theory–when asked about his personal portfolio once replied, “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier…Instead, I split my contributions 50/50 between bonds and equities.” The above portfolio is a somewhat tongue-in-cheek implementation of Markowitz’s approach.

Thoughts?

Do you have a favorite? Does your portfolio closely resemble any of the above? (For those curious, mine looks very much like the Second Grader Portfolio.)

Update: Monevator has written a revision of this article outlining Lazy ETF Portfolios for UK investors.

August 11, 2009 17 comments