ETFs: Index Funds That Trade Like Stocks

Posted May 11, 2008 | 0 Comments
tags: etfs, fidelity, how-to, index funds, investing, money, vanguard

In How to Build An Investment Portfolio, I explained the benefits of using index funds instead of the actively managed funds that dominate most portfolios put together by financial advisors. Vanguard and DFA both provide an excellent selection of indexed mutual funds, giving you the ability to implement a variety of portfolio strategies. However, buying into DFA funds is impossible for most investors, with typical $100,000 account minimums and only through approved advisors. So, the obvious solution is to open a Vanguard account, which only requires a $3000 balance. Another option is to use index ETFs, which trade like stocks, in whatever brokerage account you wish. There are hundreds of quality index ETFs available today, including ETF versions of most of Vanguard’s index funds.

What is an ETF?

An ETF is a “closed-end” mutual fund that trades like a stock at a continuously variable price throughout the day, in contrast to traditional “open-end” mutual funds that trade at a fixed price set at the end of each day. This has a number of important implications:

More Flexibility

While I don’t believe in market timing, I think it makes perfect sense to buy something you want when it’s on sale. Prices will always float up and down, but it’s nice to be able to pull the trigger when you see a discount you are happy with, rather than being forced to make a decision before you know what the eventual price will be. Also, like an eBay auction, you can set a threshold for what price you are willing to pay, called a “limit order”, then go about your work for the day, instead of sitting glued to your computer checking the price constantly.

Trade commissions

With open-end mutual funds, many creative ways exist for companies to sneak in added expenses. These include transaction fees, front and back-end loads, and 12-1b fees. Fortunately, none of these fees apply with Vanguard mutual funds held in a Vanguard account. A golden rule of investing: expenses should always be kept to a minimum.

100 Free Trades at Wells Fargo

With ETFs, you avoid the unnecessary costs that plague many mutual funds, but you add one in the form of a trade commission. Commissions vary widely from broker to broker, and often go down when you hold a certain amount of assets in your account. For example, Wells Fargo has a great deal going now where $25,000 in assets will give you 100 free trades per year. Scottrade is a good option for starters, with $7 trades regardless of your account balance.

Scottrade's Brokerage Fee Comparison Table

(click for fine print)

These trade commissions could chew off a significant portion your money, especially with smaller transactions. For instance, even with the relatively low $10 fee TD Ameritrade charges, a $1000 ETF purchase equals 1% of your investment. That isn’t negligible. You might even be better off buying a no-load, no-transaction-fee actively managed fund with a relatively low expense ratio (gasp!).

Less Flexibility

You might think the trade fee isn’t so bad, just a one-time thing that you’ll never have to deal with again once you buy your shares. But remember, trade fees are charged for each lot of shares sold and purchased, so you get hit twice if you ever want to exchange assets between funds.

This comes into full effect with normally recommended “housekeeping” chores such as portfolio rebalancing and year-end tax-loss harvesting. You might need to buy and sell from several funds, and the costs can add up quickly, making such maneuvers detrimental rather than beneficial. Also, realize that dollar-cost averaging, where you make steady regular contributions throughout the year (and get hit with a fee each time), is not well suited to ETFs. Meanwhile, it is common for open-end mutual funds to allow for tiny $100 contributions free of charge.

Lower Expense Ratios

As you can see in the table below, Vanguard ETFs usually have around half the expense ratio of the corresponding open-end mutual fund. You can consider this a trade-off for the added commission you may pay for the ETF version. If the amount you are investing makes the commission negligible by comparison, or if the commission is waived, ETFs become a more attractive, economical investment strategy, compared to using the traditional, open-end funds.

Great Selection

The selection of ETFs gets better every month as more ETFs are announced. You can build a portfolio of Vanguard index ETFs identical to their open-end mutual fund equivalents, or expand beyond Vanguard with hundreds of other quality index funds.

What ETFs Are Best?

Not all ETFs and index funds are created equal, even if they sound like the same thing. Vanguard ETFs are usually the best choice, tracking appropriate indexes with the lowest costs. There are cases where you can make a good argument for using non-Vanguard ETFs, and with a few asset classes you have no choice, due to lack of availability. In the table below, open-end mutual funds from DFA and Vanguard are compared with their ETF alternatives. Again, Vanguard ETFs are identical to the open-end fund with the same name, with the differences in cost structure outlined above.

Asset Class	DFA Portfolio		Vanguard Portfolio		ETF Portfolio
	Symbol	Cost	Symbol	Cost	Symbol	Cost
TSM	-	-	VTSMX	0.15%	VTI	0.07%
LC	DFLCX	0.15%	VFINX	0.15%	SPY	0.08%
			VFINX	0.15%	IVV	0.09%
			VLACX	0.20%	VV	0.07%
LCV	DFLVX	0.28%	VIVAX	0.20%	VTV	0.10%
LCV	DFLVX	0.28%	VIVAX	0.20%	RPV	0.30%
SC	DFSTX	0.38%	NAESX	0.22%	VB	0.10%
SC	DFSTX	0.38%	NAESX	0.22%	IWM	0.20%
SCV	DFSVX	0.53%	VISVX	0.23%	VBR	0.11%
	DFSVX	0.53%			RZV	0.35%
	DFFVX	0.46%			IJS	0.25%
	DFFVX	0.46%			IWN	0.25%
REITs	DFREX	0.33%	VGSIX	0.21%	VNQ	0.12%
Total Int.	-	-	VGTSX	0.27%	VEU	0.25%
Total Int.	-	-	VFWIX	0.40%	VEU	0.25%
Int. LCV	DFIVX	0.44%	VTRIX	0.41%	EFV	0.40%
Int. SC	DFISX	0.56%	-	-	GWX	0.59%
Int. SCV	DISVX	0.70%	-	-	DLS	0.58%
EM	DFEMX	0.61%	VEIEX	0.37%	VWO	0.25%
EM	DFEMX	0.61%	VEIEX	0.37%	ADRE	0.30%
EMV	DFEVX	0.63%	-	-	DGS	0.63%
EM SC	DEMSX	0.81%	-	-	DGS	0.63%
TIPS	DFFGX	0.23%	VIPSX	0.20%	TIP	0.20%
TIPS	DFFGX	0.23%	VIPSX	0.20%	IPE	0.18%
US Bonds	DFFGX	0.23%	VBMFX	0.20%	BND	0.11%
US Bonds	DFFGX	0.23%	VBMFX	0.20%	BIV	0.11%
Global Bonds	DFGBX	0.29%	n/a in U.S.	-	BWX	0.50%
Global Bonds	DFGBX	0.29%	n/a in U.S.	-	WIP	0.50%

You can see that every asset class and style is covered by ETFs, and the situation will only improve in the near future as more and more ETFs are rolled out to target specific markets that index investors demand.

The main distinction between international funds VGTSX and VFWIX / VEU is that the latter include a 5% allocation to Canada and are eligible for a foreign tax credit, so they are preferable in taxable accounts. Both indexes include a 20% EM allocation. For emerging markets, the clear pick is VWO for low cost and diversity. ADRE is composed of only 50 companies, which is obviously less than ideal when the fund is supposed to represent the entire economy of the world’s emerging markets. Still, it’s an alternative to VWO with increased exposure to Brazilian and Chinese markets. It actually pairs nicely with DGS, which emphasizes Taiwan, South Africa, Thailand, and Malaysia stocks, but if I had to pick just one it would be VWO. There are other EM ETFs out there, but they have significantly higher expenses compared to VWO and ADRE.

For info and commentary on US Small Value and International Small Cap ETFs, I’ll refer you to a few good articles I found:

The Best Smallcap International ETF? That Depends – SeekingAlpha.com
Seven With Small-Cap Value, ETF-Style – TheStreet.com
Domestic Small-Cap Value Funds – Altruist Financial Advisors LLC

The biggest difference between Vanguard’s BND and BIV bond ETFs is that the latter excludes Mortgage-Backed Securities, which actually make up 33% of BND. This is preferable according to advisor / author / guru Larry Swedroe.

Do ETFs Make Sense For You?

To invest in index funds with smaller account balances, you should really trade ETFs as little as possible and minimize costs with a low-cost broker such as Scottrade or TD Ameritrade. With less than $25,000 in assets, it might be best to just open a Vanguard account and use their open-end funds to avoid dealing with trade commissions altogether.

As your account balance grows and the trade commissions become more negligible, a portfolio stacked full of ETFs becomes practical. As in the case of free trades with Wells Fargo (and a similar deal from Bank of America), you can probably manage a portfolio of ETFs year after year without ever paying a trade commission. Even with $10 trades, if this is applied to a transaction of $10,000, now we’re talking about 0.1% of your investment. To an extent, that is negligible, and you will automatically recoup this within one year since Vanguard ETFs typically differ by about 0.1% in expense ratio from their corresponding open-end fund.

For more about index funds and ETFs, read Rick Ferri’s All About Index Funds. This excellent book covers the history of index funds and how to use them effectively, including important chapters on ETFs and asset allocation strategies.

He’s written a newer book more focused on ETFs, aptly titled, The ETF Book. I can’t vouch for it’s contents, although the reviews on Amazon are quite positive. I suspect it could be overkill though, as the chapter in All About Index Funds would probably suffice for many.

AndrewSwihart.net