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?
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.