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Posted by on December 9, 2006, 6:42 am
I've been looking into the benefits of owning a market index in an ETF
vs an open-ended fund. Relevant facts:
- 5K lump sum investments
- tax efficiency is important
- dividends to be reinvested
I'm comparing the discount mutual fund companies to holding ETFs in
discount brokerages. I used the Vanguard Total Index ETF (VTI) and
Vanguard Total Market Index (VTSMX) to make my original comparison
apples to apples. I'm assuming a long term holding of 10+ years and
that the investor wants to track lots (specific share method) for tax
purposes.
ETF
+ very low expense ratios (.07%)
+ most brokerage houses track lots (simplifying the accounting
paperwork)
+ ETFs may be more tax efficient
- some brokerage houses may charge for dividend reinvestment
- brokerage houses charge per-trade, assuming a $20 fee for buy;
disregarding time-cost, that's .04% per-year for 10yr holding
- brokerage houses may charge to hold an account (maybe as much as
$120/yr if holdings are less than a minimum)
- there may be an ask-bid spread (.30% seems to be an average -
buy+sell works out to $30 per $5K or .06% for a 10yr holding)
- there may be a NAV to market price spread (I'm ignoring this)
Open Ended Mutual Fund
+ low expense ratios (.19%)
+ don't charge for share purchases (including dividend
reinvestment)
- only support average cost basis accounting
According to this simplified analysis, ETFs have a razor thin edge over
mutual funds, to the tune of .17% vs .19% expense ratios. However,
assuming sells in the same size lots at the buys, I'd also add a .04%
sell commission to ETFs which would make traditional mutual funds win
by .21% vs .19%. ETFs win in the ease-of-accounting space though,
since the brokerage tracks the lots (assuming the shares stay at the
same brokerage and the brokerage doesn't change policies). ETFs have
an additional risk since brokerage houses may increase account fees or
stop free DRIP programs.
Also, while ETFs can be more tax efficient it seems that isn't always
true in practice. Is VTI actually more tax efficient than VTSMX?
They are about the same according to the three year returns on
Vanguard's site. It's possible that the VTI vs VTSMX difference is
narrow here since VTI is essentially a share class of VTSMX. I'm not
sure how the ETF is managed and perhaps spiders would be different
here.
The net result is that for the apples to apples comparison open ended
funds and ETFs are very, very close.
Did I miss anything important?
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Posted by Rich Carreiro on December 9, 2006, 9:43 am
johnrichardson_us@yahoo.com writes:
> Open Ended Mutual Fund
> + low expense ratios (.19%)
> + don't charge for share purchases (including dividend
> reinvestment)
> - only support average cost basis accounting
You absolutely can use specific share basis accounting
with open-end mutual funds. However, you need to have
the fundco send you written confirmation of your designation.
I don't know what other brokerages are doing, but Fidelity
is wonderful at tracking basis and letting you place specific
share sell orders online, for both exchange traded securities
and open-end funds.
> Also, while ETFs can be more tax efficient it seems that isn't always
> true in practice. Is VTI actually more tax efficient than VTSMX?
Depending how VTI is actually structured, it can be. The thing
that a properly-structured ETF saves you from is waves of cap
gain distributions caused by heavy redemptions.
Lets say an ETF and a similar open-end fund have been having
great years -- lots of unrealized gains in the fund's holdings.
Now some bad news comes along and investors panic and want to
get out.
When open-end fund investors cash out, the fund itself has to
come up with the cash to pay them. If enough people want out,
the fund may have to liquidate a significant amount of its
holdings and if it has lots of low-basis holdings, that's going
to mean big cap gain distributions paid out to the remaining
shareholders.
By contrast, the ETF investors are simply selling their shares
to some other investor. The fund isn't involved at all, so no
need to sell holdings to raise cash to meet redemptions. And
if a big investor wants to redeem his holdings, ETFs pretty much
all say that redemption is in kind. The big shareholder turns in
his ETF shares and receives a basket of the fund's actual holdings.
This is a tax-free exchange for the fund (and the investor), so the
fund does not realize any cap gains and so no cap gains to distribute
to shareholders due to the redemption.
--
Rich Carreiro rlcarr@animato.arlington.ma.us
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Posted by on December 9, 2006, 6:01 pm
> I don't know what other brokerages are doing, but Fidelity
> is wonderful at tracking basis and letting you place specific
> share sell orders online, for both exchange traded securities
> and open-end funds.
Sadly, to my knowledge, Vanguard isn't doing this. Also, Fidelity's
Spartan Total Market Index Fund comes in at 0.1%, which beats both
VTSMX and VTI. It's very attractive.
But I can't help but think back to not long ago when Fidelity still
sold load funds and had a 0.5% ER on index funds... and since there's a
good chance that FSTMX is losing money for the company, I'm avoiding
them for taxable accounts in case they backslide.
Although, I wonder if VTSMX and FSTMX would be considered like-kind or
in-kind investments? It would be nice to switch without tax
ramifications.
> Now some bad news comes along and investors panic and want to
> get out.
This is a good point, and it seems as if VTI would work as you
described. On the other hand, it might have to pay out if investors
bail from the underlying fund. (Can't find much evidence of a bail
during earlier bad times, but past performance is not an indication of,
etc... .)
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Posted by Mark Freeland on December 10, 2006, 2:51 pm
>> I don't know what other brokerages are doing, but Fidelity
>> is wonderful at tracking basis and letting you place specific
>> share sell orders online, for both exchange traded securities
>> and open-end funds.
There are two aspects here - one is the ability to place (and have Fidelity
acknowledge) specifice share orders, and the other is for Fidelity to track
this correctly. Fidelity is, as you said, great at the first.
However, their system can get fouled up on the latter. If you sell specific
shares before telling the system that you are switching from average cost to
specific shares (FIFO if shares not indicated), their system gets confused
about costs and doesn't seem to ever recover. Also, if you tell it you are
using specific shares/FIFO, then it can never be switched to average cost
(even though this would be legal).
> Sadly, to my knowledge, Vanguard isn't doing this. Also, Fidelity's
> Spartan Total Market Index Fund comes in at 0.1%, which beats both
> VTSMX and VTI. It's very attractive.
>
> But I can't help but think back to not long ago when Fidelity still
> sold load funds and had a 0.5% ER on index funds ... and since there's a
> good chance that FSTMX is losing money for the company, I'm
> avoiding them for taxable accounts in case they backslide.
This was a complaint that many made when Fidelity originally reduced their
expense ratio. I was one of the complainers, because I'd watched them in
the past convert their low cost Spartan 500 index into a higher cost,
non-Spartan fund, and back again. In response (not to me, but to places
like M* :-), Fidelity made the reduction "permanent" (or at least as
permanent as one can write into a fund). So I'm not particularly worried
about their index fund expenses - except for International, where they wrote
a 0.20% "permanent" expense into the fund, and not the 0.10% that they are
currently charging. (0.20% is still low, but the 0.10% is IMHO hype.)
>> Now some bad news comes along and investors panic and want to
>> get out.
>
> This is a good point, and it seems as if VTI would work as you
> described.
Vanguard (and pretty much any fund) can force large redemptions to be taken
in kind also. Further, because VTI is simply a different share class of
VTSMX, the open end shares supposedly inherit some of the benefit of ETFs.
"Vanguard reserves the right to pay all or part of a redemption in kind ...
if we reasonably believe that a cash redemption would disrupt the fund's
operation or performance ..." Prospectus, p. 53.
"With [Vanguard ETFs], investors in both the traditional fund share class
and ETF share class reap the tax efficiency created by ETF class (because
everyone's money is pooled together in the fund).
http://www.smartmoney.com/sectorpatrol/index.cfm?story=20040129
Note that VTSMX (and its sibling share class VTI) track a different index
from most other total stock market funds.
Finally, if you do invest in VTSMX, you have the option (assuming that your
broker can handle this properly - not all do) of converting your VTSMX
shares to VTI shares as a non-taxable event. There is a broker fee for this
service (VBS - Vanguard Brokerage Services - charges $50). This gives you a
way of starting out with the open end shares and if you have buyer's
remorse, changing later without tax consequences.
https://flagship.vanguard.com/VGApp/hnw/content/AccountServ/General/ATSBrokerageAcctFeesContent.jsp
(See "Vanguard ETF Shares")
FWIW, if I had an account at Fidelity, I'd use Fidelity's index fund;
likewise at Vanguard, I'd use VTSMX. With high enough balances, one can
convert to cheaper Admiral (Vanguard) or Advantage (Fidelity) shares.
Mark Freeland
BnetOnewsX@sbcglobal.net
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