Help a Reader: Least Expensive Way to Invest

Here's an email I recently received from a reader:

I just finished up the process of moving my IRA from Fidelity to Vanguard.  I am wondering if I should purchase their ETF index funds or their mutual fund index funds.  The ETF fees are lower, but you have a transaction fee when buying or selling shares which could run up costs when rebalancing.  I've checked out Vanguards ETF vs Mutual Fund calculator and it predicts that over my 30 years of saving that using an ETF would be a wiser choice, however this does not take into account the 6 month rebalancing that I would do each year.

Any insight or suggestions?

What are your thoughts for him?

Comments

[Sargonas]

Actually, if you purchase Vanguard ETFs through their Brokerage and so long as you are buy/selling less than 25 times a year per Vanguard ETF, you do not have to pay any commissions. You do have to pay the Bid/Ask Spread on the investment.

Additionally if you are not at least a Voyager customer you will have to pay a $20 / year account maintenance fee for the brokerage account.

Here is a link to Vanguard Brokerage Services Fee/Commission schedule:
https://personal.vanguard.com/us/whatweoffer/stocksbondscds/feescommissions

[DIY Investor]

If you do a lot of transactions the mutual funds should be cheaper. I'm not sure about Vanguard but many ETF providers are going to zero transaction costs. I expect Vanguard may do the same. If so then the problem is solved.

[Rob]

My IRA accounts are with Sharebuilder and if you use their automatic investment plan the fee is only $4.00. I also invest in ETFs not mutual funds and I purchase mostly Vanguard ETFs since the expenses are so low.

Another thing you could do is only rebalance once a year instead of every six months (that's what I do). But my balances are not very large at the moment so it is not making a huge difference.

If you want to avoid even more fees you could rebalance by only purchasing more shares of specific ETF and not sell any of your shares. However that option only works if you have made contributions and have cash in your account.

[jim]

Sargonas pointed out the fees are free for Vanguard ETFs. That should answer it in this situation.

In general though, paying a trading commission a couple times a year on an equity is going to be worth it unless you have a relatively small amount of money invested. Say you pay $10 to buy or sell a couple times a year. Thats $20 a year in expenses. If you have $1000 invested then that $20 is more signficant and amounts to a 2% expense. But if you've got $10,000 then that $20 is just 0.2% expense. The more you have in the investment the less a trading commission fee will matter.

[Old Limey]

Another reader is obsessing over mutual fund expenses and ignoring fund performance.
It's sad that people don't wise up and realise that if you want to do well in the stock or the bond market then if you do nothing else, the #1 thing you need to do is to practice "Fund Selection".

There have been studies done during various market periods where two theoretical investors were compared.
Investor #1 practiced the best possible fund selection and the worst possible market timing.
Investor #2 practiced the best possible market timing and the worst possible fund selection.
Investor #1 won out in every case.

Fund selection is really simple to do. All you need is to have access to families of funds where each family contains all of the funds available to you wherever you keep your money. You also need some ranking software that with the press of a few keys on your keyboard will quickly show you the best fund in any family you are interested in, when ranked by such quantities as "Annual rate of Return", "Volatility", "Maximum Drawdown", or "Risk Adjusted Rate of Return" over whatever time period you choose - such as 1 month, 2 months, 3 months, current year, one year, two years, or whatever. This way you can make an intelligent decision about which fund to invest in. Alternatively would you rather ignore performance, and invest, for example, in a fund that has returned 10% over the last year but has an expense of 1%/year or a fund that has lost money over the last year but only has an expense of 0.25%/year.
I think the answer is obvious. Fund Selection has worked great for me for the last 18 years and I haven't had a losing year since 1994. I also take note of what the overall market is doing, and act accordingly, but Fund Selection alone will do that as well, because if you do your fund selection and nothing looks attractive - guess what? - you just don't invest until you are able to find something that looks like it will make some money for you.

I have told you what works for me and lots of people that I know, in both good and bad markets, but the rest is up to you.

[Anthony]

@Old Limey:

It doesn't specifically say it in the article, but the assumption is that we're comparing an index fund vs. the ETF equivalent of the index fund. The reader is not ignoring the fund's performance. They are comparing the mutual vs. an ETF of the same fund. The fund performances, then, are identical.

Let the fee vs. commission debate continue! :)

[MikeG]

There are a number of brokers that will let you trade for free if you had a certain amount of money in total (usually $25k). If you dont have that amount, you can probably go with a low cost broker to get the cost per trade under $5, or you could get an account directly with the ETF provider and possibly may no commission at all (as the comments above mention).

I have two reason you should choose the ETFs over Mutual Funds:
1) There are major tax advantages to owning an ETF vs. the comparable Mutual Fund. Mutual Funds need to pay you short term cap gains and long term cap gains whenever they make money selling stocks. And whenever that happens, you get taxed. With ETFs, the tax structuring is more efficient. Most of the fund's gains (both long and short) are rolled into the value of your investment so you don't have to pay the cap gains tax until you sell. Now this may not matter too much if your investing within an IRA, but it WILL help you out when you retire and start taking money out. All (or almost all) of your investment will be Long Term and taxed at the lowest rate possible.

2) ETFs (especially Vanguard ETFs) have super low expense ratios. For example, the Vanguard Total Stock Market Index Fund (VTSMX) has an expense ratio of 0.18%, while its ETF counterpart, Vanguard Total Stock Market ETF (VTI), has an expense ratio of only 0.07%. Its a small difference, but wouldn't you rather keep that 0.1% every year and let it compound? *One caveat to this is that if you have $100k+, you can upgrade your mutual fund share class and knock the expense ratio down to ETF levels, so if you have enough cash, the cost advantage disappears. =)

[CPA Abroad]

@MikeG: I think your first point is not entirely correct in the context you use it. What you say is correct for a taxable account, but if you have an IRA, deductible, non-deductible or rollover from a 401k, the withdrawn money will come out as ordinary income subject to marginal tax rates as it was not previously taxed. One distinction that should be made is for a non-deductible IRA, only the earnings are taxed at the marginal rate (i.e. original contribution comes out tax free), whereas for a deductible or 401k rollover IRA the entire amount is taxed at the marginal rate (i.e. nothing comes out tax free).

While not mentioned previously, for a Roth IRA, it all comes out tax free, as the contribution was previously taxed. This is why, if you are over the income limits for a Roth contribution, it is good to make a contribution to a non-deductible IRA and then immediately recharacterize it into a Roth because as a Roth, the earnings are now tax free as well (caveat: this is for current year contributions when you zero, or only a small amount, in previously established deductible or non-deductible IRAs. Once you have a decent sized balance in your deductible or non-deductible IRA, the math becomes more complex in determining whether the recharacterization makes sense).

[PMT]

@Old Limey

The fact is that fees matter and are the only thing you can completely control. Sure I can research performance and research fund managers and research the research but the fact is we have little control on the actual outcome as that is dictated by market forces. This is especially true of index funds. Controlling fees and commissions is a very important part of fund selections and should not be discounted.

[Old Limey]

@PMT

Here are comparisons of the two mutual funds that I currently own against their ETF counterparts.
My two mutual funds were selected, by my own ranking tools as being the best available for performance in their respective fund categories. My data provider has all of the thousands of available funds and ETFs split up into several hundred fund categories which greatly facilitates finding the best performers in any category.

Fund #1 A Pimco bond fund - expense ratio 0.9% - One year gain 10.34% (after expenses)
Corresponding ETF - expense ratio 0.25% - One year gain 7.63% (after expenses)

Fund #2 A Wells Fargo bond fund - expense ratio 0.8% - One year gain 13.53% (after expenses)
Corresponding ETF - expense ratio 0.25% - One year gain 7.98% (after expenses)

Both of my funds have no transaction fees which is nice since I have made 13 Buys of one and 6 Buys of the other for which there have been zero commissions. I use the two funds for reinvesting interest from the CDs and Municipal Bonds that I plan owning to maturity in our IRAs and Trust account.

Even in the Glory days of the Hi-Tech Bubble I paid no attention to expense ratios even when a few funds I owned had 2% expenses - they were worth every penny.

As you say, I have no control over market forces but I have total control over the fund categories and individual funds that I buy and sell, and that is what has made me a very successful investor since I retired 18 years ago. Regardless of market forces there are usually a few categories that are doing well, so why not be in them rather than a very broad index.

[jim]

Old Limey,

Are you comparing a Pimco mutual fund to a Pimco ETF that are tracking the exxact same set of investments or are they just 'similar' in nature? Pimco only has a handful of ETFs and they don't seem to be directly corresponding to similar Pimco mutual funds.

Your point is valid that "similar" mutual fund and ETF are not necessarily going to give the same exact results if they are actively managed or if the nature of the investments differs.

But if you're looking at Vanguard ETF's vs funds then you can get the same results. Vanguard ETFs and mutual funds are tracking the same index. So if you buy their total bond fund (VBMFX) or their total bond ETF (BND) then you get investments tracked to the same thing. Looking at price and dividend payments BND and VBMFX have had EXACTLY the same return from the creation of BND in 2007 till today. Both are up 22.4% from April 10 2007 to today.
(I didn't reinvest dividends to make the math simplier).

[jim]

In fact, I think that the Vanguard ETFs are basically just an ETF representation of the Vanguard mutual fund. I'm not 100% sure on that but I think thats how its structured. They aren't really separate funds but if you buy the ETF you're really just buying shares of the mutual fund in an ETF vehicle.

[Old Limey]

Jim:
It does appear that you are correct about the two Vanguard funds. From 4/11/2007 until yesterday BND is up 24.68% and VBMFX is up 24.74%. This assumes that the dividends are automatically reinvested into additional shares, as is the default situation. The small differences in the charts of each fund are due to large differences in the sizes of the respective daily NAVs and monthly dividends, numerical rounding, and possibly because BND is priced throughout the day and VBMFX is priced at close of business, and a small difference in expense ratios. I am unaware of any other mutual fund companies that have duplicate types such as this. Judging by the published holdings of each fund they appear to differ primarily in mame only. Fidelity and Pimco do not have their own ETF funds nor do any of the larger fund companies that I know of.
This means that when I am comparing an ETF with a regular fund of the same category there will usually be a very significant difference in results because in most cases the holdings will be quite different. For any particular category there are also far more regular mutual funds than ETF funds so by selecting the best of the regular mutual funds I would expect my fund to outperform an equivalent ETF fund. ETF funds are also only a few years old whereas regular funds no doubt go back to even before the start of the database I use which is 9/1/1988.

[JimL]

Old Limey,

Can you give a recommendation on the data provider/software you mentioned in an earlier post.

[Old Limey]

JimL
The company that I have used, since first discovering it in Investor's Business Daily in 1992 is called Investor's FastTrack in Baton Rouge, LA. The annual fee for the database, updated every market day, for approx. 10,000 funds, ETFs, and Market Indexes is $403 annually including the analysis, charting, and updating software as well as all of the 662 fund families, besides families you can create yourself as needed. There are also options for monthly and quarterly rates. They have a 30 day free trial. It takes quite a lot of time to get up to speed with all aspects of the software but the tech support are very good in answering any questions about how to use portions of it. I used to have a 3rd. party product that accessed the database that was very popular with subscribers, because it was very easy to use, but I stopped making it available to new users in July 2008 when it started running out of DOS memory. Investor's FastTrack has all you could ever need in analysis and charting capabilities and the one feature it has that most charts on the Internet, and the prices in the newspaper don't have is that their data is adjusted for all distributions and dividends. This is absolutely essential when analyzing, researching, and comparing income funds since most of them have significant monthly or quarterly dividends in the form of new shares.
Please be assured that I receive nothing whatsoever for recommending them to others.