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Replacing Index Funds in Your Portfolio

One of the most reliable ways to improve your investment returns is to reduce the investment costs you’re paying. That’s why low-cost index funds (or ETFs, if you can buy them without a commission) are my investment vehicle of choice.

From time to time, however, people ask me whether it makes sense to put together a portfolio of individual stocks–not to beat the market, but simply to reduce costs. After all, individual stock holdings have no ongoing costs, whereas even low-cost index funds cost something.

It’s true that, depending on how much you pay for stock trades, you could reduce your costs that way. And if you’re investing in a taxable account, it could provide additional tax loss harvesting opportunities as well.

But is it Worth the Hassle?

At a very minimum, I wouldn’t be comfortable replacing my U.S. stock index fund with less than 25 holdings or so (for instance, 2 or 3 companies from each of the 10 industries/sectors listed here). And the same goes for my international stock index fund.

Surely many investors would see things differently, but setting up and tracking a 50-stock portfolio doesn’t sound fun to me.

And the amount of money you stand to save isn’t exactly astronomical. For example, if the stock portion of your portfolio was, let’s say, $600,000 and it was allocated 2/3 in Vanguard Total Stock Market and 1/3 in Vanguard Total International Stock, then the most you would stand to save in fund expenses would be $680 per year. (And that’s if you paid exactly $0 for commissions on your stock trades.)

For some investors–those with very large portfolios or those who don’t mind additional complexity–the savings may be worth it. But if (like me) you place a lot of value on simplicity, it just doesn’t make sense.

What about Replacing Your Bond Index Fund?

For two reasons, I’d argue that it’s more likely to make sense to eliminate the bond index fund in your portfolio and replace it with individual holdings.

First, Treasury bonds and CDs carry as close to zero credit risk as is possible (assuming you stay under the FDIC limit). As a result, you don’t have to diversify nearly as broadly as you would when replacing a stock index fund. A handful of Treasury bonds or CDs–one of each of, say, 5 different maturities–would be perfectly reasonable.

Second, you can often find higher yields on CDs than on Treasury bonds of similar maturity–thereby allowing you to increase your return without a meaningful increase in risk.

But again, it’s more hassle–shopping around for the best CD rates rather than just funneling money into the same index fund every month. Only you can decide whether or not that makes sense for you.

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Comments

  1. If you don’t want to go through the hassle of dividing your portfolio into 25 or more smaller stock funds, and you would prefer to keep your investments centered in a broad-based total stock market/total international market fund, I would advise this simple method of diversifying:

    Invest your cash in total market funds that track different indexes. Vanguard’s Total Stock Market Index Funds tracks the MCSI U.S. Broad Market Index. Schwab’s Total Stock Market Index tracks the Wilshire 5000 Composite Index.

    This basically means that the two funds — which share the same goal — use different methods to achieve that shared goal; they track two different broad-market indexes. An easy way to diversify is by putting half of the money you want to allocate to domestic market funds in one of these, and half in the other.

  2. Hi Paula.

    I suspect I might be missing something. :)

    What would be the benefit of doing that as opposed to sticking with just one of the two funds?

  3. I think it is well worth the hastle if it is increasing your ROI in your investment portfolio

  4. @Mike: “First, Treasury bonds and CDs carry as close to zero credit risk as is possible (assuming you stay under the FDIC limit). As a result, you don’t have to diversify nearly as broadly as you would when replacing a stock index fund. A handful of Treasury bonds or CDs–one of each of, say, 5 different maturities–would be perfectly reasonable.”

    OK, but doesn’t the short-term bond fund do the same thing for you without the effort of having to buy individually at different maturities? And the total bond fund gives you the advantage of having some corporate and foreign bonds in addition to the US treasuries.

    The FDIC limit, I assume, applies only to CDs and not treasuries. But it would seem, implicitly, that you’re discounting any of the noise regarding US credit risk that we’ve been hearing of late. (Did you see David Stockman’s editorial in yesterday’s NY Times?) I tend to think too that US credit risk is minimal and I’m not about to dump all my treasuries à la Pimco, but still I can’t help but feel concerned, especially as I’m getting to the age where it’s usually recommended to weight bonds more heavily in the overall allocation.

  5. OK, but doesn’t the short-term bond fund do the same thing for you without the effort of having to buy individually at different maturities?

    Yes, that’s exactly what it does. But it has an ongoing cost. My point was just that by buying the bonds yourself, you can reduce costs (very slightly).

    Or, if you go with CDs, you can reduce costs (very slightly) and potentially find (slightly) higher yields as well.

    “The FDIC limit, I assume, applies only to CDs and not treasuries.”

    Correct.

    “But it would seem, implicitly, that you’re discounting any of the noise regarding US credit risk that we’ve been hearing of late.”

    Not entirely. Though as we’ve discussed, it would seem to me that a high inflation scenario is far, far more likely than an actual default scenario. And in such circumstances, all fixed-income investments denominated in nominal US dollars will be hurt, not just Treasuries.

    Going to go read the Stockman article now…

  6. Larry: Having read that article, I don’t think I can say much about it either way here while maintaining the no-politics environment that I try to create here.

    So, email on the way. :)

  7. Mike: you gave lip service to the value of tax loss harvesting, but didn’t calculate the value when you dismissed the $680 in ER savings as being paltry. And don’t forget the other tax management benefits. Such as lowering the dividend yield. Donating highly appreciated shares to charity. Gifting appreciated shares to children.

    Personally, I believe individual stocks can only make sense in domestic large cap stocks – where you can get decent diversification with the 25+ stocks that you suggest. I don’t believe you can get decent diversification in small caps or international without an awful lot more stocks than an individual would want to manage.

    For the vast majority of investors, the complete diversification and ease of dealing with an index fund outweigh the slight cost and slight tax inefficiency of an index fund. But if you want to own individual stocks, I would recommend them only a) in a taxable account that is tax managed, and b) for domestic large caps only.

  8. Andy: You’re right, of course, that I didn’t include the tax savings resulting from tax loss harvesting. My reasoning, frankly, was that I don’t have any number to use.

    I haven’t come across any good studies that attempt to get a ballpark figure of what those savings would be (tax loss harvesting savings of individual stocks as compared to tax loss harvesting savings on a simple index fund portfolio). If you’re aware of any, I’d be very interested.

  9. Mike: If one frets about 0.11% annual expenses for index funds, then perhaps the bid/ask spread for any stock trading shouldn’t be neglected, either. Prof Jeremy Siegel estimated it at 0.4% for large cap stocks and 2.65% for US small caps, but that was 14 years ago. Trading friction has gone down . . . . any idea what that hidden cost averages nowadays?

    Buying an index mutual fund avoids that bid/ask spread cost, except as a tiny hidden ongoing cost due to turn-over, which is very low for a broad index fund anyway.

    Tax loss harvesting is more or less the opposite of rebalancing, and wash sale tax rules leave one out of the stock for 30 days, leading to more tracking error. For anyone who is just seeking market returns, that seems like a lot of work and tracking error to delay some inevitable taxes and avoid a 0.11% ER.

  10. Mike: here is an excellent article that quantifies the benefits of tax loss harvesting:

    http://www.firstquadrant.com/downloads/Loss_Harvesting.pdf

  11. Dale: That’s a great point re: bid/ask spread incurred by building a stock-by-stock portfolio.

    Andy: An interesting paper, but I’m not sure how well the conclusions apply to individual investors. They’re assuming replacing an index fund with 500 stocks and checking monthly for loss-harvesting opportunities.

    • That’s a ton of work. Frankly, I can’t imagine any individual investor (as opposed to a fund manager) doing this.
    • I didn’t see any mention of costs (brokerage commissions and bid/ask spreads) incurred on these trades.
  12. As a fledgling Value Investor(tm), the biggest problem I have with Index Funds is that I haven’t been able to find a reliable method of valuation. Sure, I could just keep buying VTV every couple of weeks, but how do I know I’m not overpaying?

  13. Rob: To some extent, that’s what rebalancing attempts to take care of–selling off various asset classes after they’ve performed well and buying those that haven’t performed as well.

    Some index fund investors take things a bit further. For instance The Finance Buff writes about a method he calls “overbalancing.” Others use specific valuation measures to shift allocation over time. (See Wade Pfau’s article, for instance.)

    I do neither, but I wouldn’t think a person crazy for attempting such methods. I’m satisfied knowing that, yes, at time I will most certainly be overpaying. At other times, however, I’ll be getting a bargain. That’s good enough for me.

  14. Mike: I don’t see why an investor with 25+ stocks cannot replicate much (if not all) of the tax loss harvesting benefits. If you want to dial down the savings a bit, do so. But ignoring the very real benefits of TLH simply distorts the equation.

    Tracking 25 stocks once a month takes less than a minute. Your stocks are already loaded into one of dozens of free portfolio sites on the web. Download the data into your Excel spreadsheet, and you see any losses immediately. Hand load the data if you want. It takes one minute.

    I am not sure why you are focused on commissions or bid-asked spreads. The index fund pays these too, and you have less (bad) turnover than the index fund. You don’t have to buy or sell every time the index is reconstituted. The tax loss harvesting is a benefit which should be viewed net of costs. This is exactly what Vanguard’s Tax Managed funds do….and nobody frets over their transactions costs. By the way, many people – myself included – don’t pay commissions.

    Your portfolio of stocks is like a Tax Managed mutual fund. No different. But you trade off a little less diversification for the clear benefit of being able to generate tax losses (which the TM fund cannot flow through to you).

  15. Andy: Yes, trades can be obtained commission-free. In most instances I’ve seen though, there’s a limit to the number of free trades (x free trades per year or per month, for example). It seems to me that a 500-stock portfolio would likely exceed such limits. I don’t know by how much, so I can’t say whether that cost would be significant or not.

    To back up a step: I’m not trying to argue that the tax-loss harvesting benefit would be zero. Nor am I trying to argue that it would be insignificant. It wouldn’t be. That’s why I mentioned it in the article. I just don’t know how large that benefit would be. And I’m not entirely convinced that the particular figures provided by that paper are necessarily a good estimate for individual investors attempting to replicate them (especially if fewer stocks are used).

  16. Mike: as a Vanguard Flagship investor, I get 25 free trades a year. That is ample to a) initially assemble a 25 stock portfolio and b) tax loss harvest fully each year. If you don’t qualify for Flagship, you don’t have enough assets to make this strategy work anyway.

    I am not sure why you don’t feel that a 25 stock portfolio won’t generate a comparable TLH benefit. The portfolio needs to be large enough to have similar characteristics to the overall asset class, but that is all. For example, if 20% of the S&P500 stocks have a loss each year, then I would expect 5 of my stocks to have a loss – with a similar magnitude. Harvesting 5 stocks from my portfolio should generate similar and proportional benefits to the person harvesting 100 stocks from a 500 stock portfolio.

    In my opinion, the appropriate way to evaluate such a strategy is to value a) the tax benefits, b) the cost savings, c) your time and d) the slightly inferior diversification. These are certainly not easy calculations, but without a decent estimate you cannot tell if the strategy makes sense (for you) or not. BTW, I estimate the value of the diversification impairment for a 25 stock large cap portfolio at around 0.4% per year….reflecting the higher standard deviation from a smaller portfolio.

  17. “The portfolio needs to be large enough to have similar characteristics to the overall asset class, but that is all. For example, if 20% of the S&P500 stocks have a loss each year, then I would expect 5 of my stocks to have a loss – with a similar magnitude. Harvesting 5 stocks from my portfolio should generate similar and proportional benefits to the person harvesting 100 stocks from a 500 stock portfolio.”

    Point taken. Thank you for the further clarification.

    “As a Vanguard Flagship investor, I get 25 free trades a year. That is ample to a) initially assemble a 25 stock portfolio and b) tax loss harvest fully each year.”

    My understanding was that their simulations assumed that the portfolio was checked for TLH opportunities monthly. Are you saying that even when checked monthly, 25 trades per year is enough? Or do you only check annually? And if you only check annually, wouldn’t that reduce the benefit below the figure in the paper?

    As to your earlier comment about the work involved, I agree that there would be very little work to do the actual periodic check for TLH opportunities. Still, it seems to me that the recordkeeping involved would be significant–not unbearable, but meaningfully more than that involved with a single fund.

  18. Mike: I think one needs to downgrade the benefits of TLH from the Arnott paper for several real-world issues:
    a) You probably won’t harvest each month, especially if the loss is tiny.
    b) Your benefits – tax reduction – are limited by the $3,000 cap on tax deductions against ordinary income. The authors assumed you offset the capital losses against capital gains from other parts of your portfolio…..but I don’t buy that. If you are leaking capital gains from other parts of your portfolio that is another problem and you need to deal with that by investing in more tax efficient assets.
    c) In an unusual situation – you have a significant amount of new money AND the market tanks – you will harvest more than 25 times. As a Flagship investor, I pay $2 per trade over 25 trades.
    d) I don’t assume the deferred gains are never realized. Arnott shows one case where the gains are never taxed…since the stocks are bequeathed. But I prefer the more conservative case of an individual benefitting from tax deferral for many decades.

    Overall, a real-world application of TLH will certainly show benefits. Arnott showed (paying taxes at 25 years) an average annual benefit of 0.53%. Personally, I believe the real-world benefits are less, but the holding period can be longer than 25 years. In my opinion an estimate of 0.4% or 0.5% is reasonable.

  19. Andy:

    Trading costs are zero to *buy into* an index mutual fund, unlike a stock portfolio. That’s a tiny bid/ask spread expense with large caps for those with commission free trades, but I’m not sure why you totally discount it.

    Theoretically, Vanguard’s Tax Managed Growth & Income should be better in a taxable account than their comparable S&P 500 index fund, mostly because of tax loss harvesting. If anybody can tax manage index funds well, it would probably be Vanguard. Their current 10-yr return numbers after taxes only show about a 0.05% or 0.06% annual advantage for Tax Managed over plain S&P 500 index. That’s an order of magnitude less advantage than the FirstQuadrant article projects for an individual who tax harvests his own stock portfolio. Why such a large gap — or small gap, depending on which way we look at it?

  20. Dale: the reason I discount the bid-asked spread is that both people pay it. When I buy stocks, I pay the spread. When Vanguard buys additional shares (when you purchase the fund), it pays as well. Another reason it is essentially irrelvant is that you buy once, and hold for a long time (unless you TLH). So the bid-asked spread is paid once, rather than every year. And…your fund has more turnover (when the index changes), so they pay the spread on an ongoing basis.

    I am not sure how the “after tax” returns from the TM Growth & Income fund is measured, but it is important to understand that a mutual fund cannot pass a tax loss to you. So, the fund can generate the losses, but you cannot use them as an individual. The fund can only offset capital gains with its losses. But I can offset $3000 of ordinary income each year. That is where the major benefits come from. For that reason, the after-tax numbers you quote are probably not relevant….since they don’t include the $3000 tax loss deduction.

    You may say, “but I can sell the mutual fund to generate a TLH”. Sure. But in a year when the fund has a 2% gain, you cannot TLH. But I can – and do – cherry pick a bunch of losers out of my portfolio in that year. Even though the entire market is up, maybe 30% of individual stocks are down.

  21. Andy:

    Alas, when *I* buy shares of an index mutual fund, Vanguard doesn’t rush out to buy additional stocks. Even if an index fund simply rebalanced holdings by the next day, it would only need to pay market transaction costs on the net difference between shares bought and shares sold each day. The internal fair swap at end-of-day NAV for buyer and seller avoids much of the frictional drag. (A mutual fund’s ER includes the internal bookkeeping expenses, and being able to utilize internal transactions without any risk and thus often avoid the market maker in the middle who is trying to make a profit should help keep expenses lower, no? )

    The cost of either passive strategy can be so low nowadays that other factors tip the decision. For most passive investors, the simplicity and convenience and extremely low tracking error of the Vanguard Total Stock Market Index fund (for instance) make it an obvious choice over managing 25+ large cap stocks plus managing smaller cap exposure. For a large taxable portfolio, you make a good case that US tax law could give a slight edge to the more complex option allowing significant TLH,

    I was assuming that a TM index mutual fund’s loss harvesting could offset/defer taxes on its capital gains or dividends (mostly LT at a 15% tax rate currently), which as you rightly note is not nearly as good as offsetting/deferring taxes on some ordinary income at up to a 35% marginal Federal tax rate. Maybe I’m being too simplistic or oblivious here, but if a mostly passive stock portfolio might offer 0.4 or 0.5% tax alpha, is it not reasonable to expect a 0.2% or so tax alpha from loss harvesting by a TM index mutual fund? I’m seeing less advantage by my spot check of large cap TM fund performance. BTW, Vanguard removed their long-standing 1% within 5-yr redemption fees on domestic TM funds just this past week. A TM index fund probably belongs in this discussion as a third option for taxable equity investments for the passive investor.

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