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Do Vanguard Funds Have Hidden Costs?

A reader writes in, asking:

“I recently met with a financial advisor to look over my portfolio. Currently, I use the ‘three fund portfolio’ that is recommended on the Bogleheads website: Vanguard’s total stock, total international, and total bond funds. The advisor said that while Vanguard index funds are OK, he thinks they’re over-rated because they have hidden costs and they aren’t actually as cheap as Vanguard states in their marketing. Is that true?”

Every typical mutual fund (index or otherwise) has “hidden costs” as a result of portfolio turnover. That is, when a mutual fund buys or sells investments, it incurs costs in the form of commissions and bid/ask spreads. And these costs are hidden in the sense that they are not included in the fund’s reported expense ratio, despite the fact that they have a downward drag on performance.

What’s ironic about this advisor’s assertion is that:

  1. Index funds (especially “total market” funds) tend to have very low turnover costs, and
  2. It’s much easier to estimate an index fund’s turnover costs than an actively managed fund’s turnover costs.

In other words, relative to the hidden costs of actively managed funds, the hidden costs of index funds are typically a) less hidden and b) lower.

Why Index Funds Usually Have Lower Turnover Costs

The reason why index funds typically incur lower portfolio turnover costs than actively managed funds is simple: index funds generally have a lower rate of portfolio turnover.

For example, Morningstar currently reports that Vanguard Total Stock Market Index Fund has annual portfolio turnover of just 3%. Look up any handful of actively managed stock index funds, and the most likely outcome is that all of them will have portfolio turnover well in excess of 3% per year.

How to Estimate the Turnover Costs of an Index Fund

With index funds, it’s pretty easy to get an idea of the magnitude of such hidden costs. To do so, check how the fund’s long-term performance compares to the performance of the index that it tracks. For example if:

  • A given index has an annual return of 7.0% over the last 10 years,
  • A particular index fund tracking that index has a return of 6.85% over those 10 years, and
  • The fund has an expense ratio of 0.1%…

…then we can estimate that the fund’s “hidden costs” are in the ballpark of 0.05% per year. (That is, if the fund’s performance trails the performance of its benchmark by 0.15% per year, and the fund has a 0.1% expense ratio, the remaining 0.05% performance gap serves as a decent estimate of such “hidden” portfolio turnover costs.)

With regard to the advisor’s assertion about Vanguard specifically, it’s worth pointing out that, in many cases, Vanguard’s index funds actually trail their benchmarks by an amount that’s less than their expense ratios. In other words, the hidden costs are sufficiently small that they are outweighed by the “hidden revenue” the funds earn from securities lending.

Investing Blog Roundup: New Fiduciary Duty Rule for Financial Advisors

The big news this week is that the Department of Labor released the final version of its new fiduciary duty/conflict of interests rule for financial advisors. If you’re interested, you can find the actual text here.

The following articles explain the gist of the new rule:

And the following articles discuss some ways in which the final rule differs from the proposed version:

Investing Articles

Other Money-Related Articles

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Can You Double-Count Earnings for IRA and 401(k) Contributions?

A reader writes in, asking:

“My spouse is retired, and I recently began semi-retirement, working just a few days each month. Because of a pension and paid off house, we won’t be spending from our retirement savings. My question regards contributions to retirement accounts with a small amount of income.

My employer offers a 401k. Let’s say I earn $10,000 in 2016. Can my wife and I each contribute the maximum to a Roth IRA? Essentially what I’m asking is can we each count the $10,000 as income? And does that change if I contribute to the 401k?”

First let’s back up a step for readers unfamiliar with this topic. In addition to the normal IRA contribution limits, there is also a rule which says that your IRA contributions for each year are limited to your compensation for that year (i.e., wages, commissions, self-employment earnings, alimony, and nontaxable combat pay).

There is an exception to this compensation-related limit for married people, but for the moment let’s focus on the simpler situation of an unmarried person.

Contributing to a 401(k) and IRA

Your IRA contribution is limited to your compensation for the year. For people earning wages (as opposed to self-employment income) the relevant amount is the amount reported in box 1 of Form W-2. Of note, that figure has already been reduced by any pre-tax (i.e., “traditional”) 401(k) contributions that you make for the year. In other words, if your earned income is low enough, contributing to a pre-tax 401(k) would reduce the amount of IRA contributions that you can make.

Example: Beth earns $5,000 this year. If she doesn’t contribute anything to a retirement plan at work, she can contribute the entire amount to a Roth IRA.* However, if her employer offers a 401(k) and she decides to make pre-tax contributions to that plan, those contributions would reduce the amount of wages that show up in box 1 on her W-2, thereby reducing the amount she can contribute to her Roth IRA.

Things work differently, however, if it is a Roth 401(k) to which you are contributing at work. Specifically, the amount of wages reported in box 1 on Form W-2 is not reduced by the amount of Roth 401(k) contributions that you make. In other words, you can essentially “double count” your earned income by contributing to a Roth 401(k) and a Roth IRA.

Example: Beth earns $5,000 this year. If she contributes $5,000 to a Roth 401(k), she can still contribute $5,000 to a Roth IRA.

Spousal IRA Contribution Limits

As mentioned above, there is an exception to the rule that your IRA contributions for each year are limited to your compensation for that year. Specifically, in a married couple, for the spouse with the lower amount of compensation for the year, the compensation-related limit is calculated as:

  1. The compensation of the spouse in question, plus
  2. The compensation of the other spouse (i.e., the one with higher earnings), minus
  3. Any IRA contributions the other spouse (the higher-earning one) has made for the year.

Example: Bob and Jane are married, both age 60. Bob is retired. Jane still works part-time, earning $20,000 per year. Jane does not contribute to a retirement plan at work. She does, however, contribute $6,500 to a Roth IRA for the year. Despite having zero compensation for the year, Bob can also contribute $6,500 to a Roth IRA, because Jane’s compensation is sufficiently high for both of them to make contributions.*

A key point here is that spousal IRAs do not allow for “double counting” of income. For example, if Jane in our previous example only earned $5,000 for the year and she contributed $5,000 to a Roth IRA, Bob wouldn’t be able to make any Roth IRA contribution.

*For the sake of simplicity, we are assuming here that the MAGI-related income limits are not an issue.

Investing Blog Roundup: Employer-Employee Disconnect Regarding 401(k) Savings

This week, the Center for Retirement Research at Boston College discusses a recent survey which showed a significant disconnect between employers and their employees when it comes to 401(k) plans. Specifically, employers are more likely than their employees to think that 1) the employees are saving enough, 2) the employees understand the investment options in the plan, and 3) the employees understand how much they should be saving.

Investing Articles

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Where Does the Money Go When the Market Is Down?

A reader writes in, asking:

“One thing I’ve never understood is where the money goes when the stock market goes down. Let’s say the market is down a collective $100 billion over a period of time. Did the money just disappear? Did it go to cash or some other asset? I have the same question when the market is up. Where’s the money coming from?”

The money doesn’t go anywhere, per se. If the stock market’s value is down $X, it isn’t because $X actually moved out of the stock market and into other asset classes. What’s actually going on is easiest to explain by analogy.

Imagine that you buy a home for $300,000. One year later, you hire a qualified appraiser to assess the value of your home. His answer is that based on recent sales of similar homes in the area, your home is now worth $270,000. Your home declined in value by $30,000, but that $30,000 didn’t go anywhere. And no cash has even changed hands at all.

And the same thing can of course happen in the other direction. (That is, your home could increase in value without any cash changing hands.)

A similar thing happens with stocks. The difference is simply that the most recent price at which the stock has traded is generally considered to be the current value.

For example, imagine a company that has 1 million shares of stock outstanding. If the stock is currently worth $90, the company’s total market capitalization (i.e., total value) is currently $90 million.

Now imagine that you have 1,000 shares of stock in this company, and you want to sell it. But at this particular point in time, the highest price anybody happens to be willing to pay for the stock is $89.

You sell the stock, meaning that $89 is now considered to be the market value for each of the company’s 1 million shares. So the total market capitalization of the company is now $89 million, or $1 million less than a few seconds ago. But only $89,000 has changed hands. And, in total, no money at all actually came into the market or left the market. (The buyer put $89,000 into the market, but you took $89,000 out of the market.)

In other words, the market can go up (or down) by quite a bit with only a relatively small amount of money changing hands. This is a result of the fact that when shares of a company are traded at a new price, all shares of that company (or more specifically, all shares of the same share class of that company) are now valued at that new price.

Investing Blog Roundup: Roth IRA Flexibility

Roth IRAs are of course intended primarily for retirement savings. But, as Vanguard’s Maria Bruno reminds us this week, Roth IRAs are very flexible, and isn’t necessarily a mistake to use the money for other purposes.

Investing Articles

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