Low cost funds into ETFs?

[Olav23]

Hi all, first time poster.

I was wondering what your opinions were as far as going from low cost index funds to ETFs. Here's my situation.

I am currently sitting on about 120k in mostly cash that needs to go into some index funds. I was considering opening a vanguard account purely to access the low cost funds. Generally I keep the money in TD Waterhouse.

Instead I thought a better idea might be to immediately allocate this money into ETFs through TD (since commission is only 11$ as opposed to 30$ at vanguard) since its a lump sum. Then, as I accumulate more, I add it to the low cost funds available at TD (a few dreyfus funds, a TD or American S&P fund etc) then when it gets to be a big enough amount, maybe 10k per fund) dump the funds and again move into the lower cost ETFs. (since I def don't want to dollar cost average into an ETF!)

Basically, I have read 2 good points for this.

1. the easiest, is lower cost funds. Lower cost = more returns over the long run.

and 2. The most important reason, Tax loss selling. As I understand it, I can simply sell off a bad performing ETF, and buy a similar ETF, take it as a tax loss against income and capital gains. This is of course much harder to do with funds.

Any opinions? Is it not worth the tax efficiency? I understand that 3k can be used against income and the rest can basically be brought from year to year. It seems like a very sweet benefit that can squeeze out a few more percentage points per year! (unless I have oversimplified something)

Any opinions would be greatly appreciated!
Olav

 

[Newell]

Three things convinced me as to the benefits of ETFs and you mentioned two of them. Lower expense ratios, flexibility in regards to tax loss selling and the ability to buy or sell during the trading day rather than at market close.

 

[Olav23]

Well, the buying/selling during the trading day is kinda a bit of a no-extra-value to me. I am 27 years old and plan on holding until I retire. Hopefully in my mid 40s (if all goes according to plan!)

The trading during the day only goes to cause hyper-active-trading disorder in me! But since this is a buy and hold account, I can keep my grubby hands off them to fulfill my goal.

Thanks for the response!

 

[charlie]

The downside of using ETF's is when it comes time to rebalance.
The commissions will eat into your lower ER if you rebalance
frequently with relatively smaller amounts.

Cheers,

Charlie

 

[cute fuzzy bunny]

I'm missing on what the problem is with losses against fund sales and why ETF's are any better or worse.

 

[malakito]

Olav23,

I don't know where you got the $30 from. Vanguard charges no transaction fees if you invest with them directly into their mutual funds. There are some fees for small accounts if you invest in their index funds, but with $120K you wouldn't be paying those.

Also, the tax loss selling is just as easy with mutual funds as it is with ETF's, you just can't do it intraday.

I think your point about ETF's having lower expense ratios is probably true.

malakito

 

[Newell]

I'm missing on what the problem is with losses against fund sales and why ETF's are any better or worse.

You may be correct. The objective, obviously, is to avoid the transactions being considered a wash sale. It seems that with ETFs, there are more opportunities to sell a position for a tax loss and replace the position with another ETF that's different enough to avoid the wash sale rules. Admittedly, there are a number of funds available for doing this, but there are not very many with reasonable expense ratios.

In practice, I've found that using index funds AND ETFs gives me the most flexibility.

 

[Olav23]

I'm sorry. I should clarify. The $30 I spoke about was using Vanguard as your brokerage and buying ETFs through them when you amass enough in their funds to make the moving to an ETF worth the commission. $30 is quite prohibitive in my opinion unless you have a huge lump to invest.

And as far as switching funds for tax loss selling, there are a few points.

1. Vanguard, (I believe) charges you a penalty of around 1% I think for selling FUNDS (not ETFs) after holding for less than a year. There goes the low cost advantage.

2. With ETFs you can yearly tax loss harvest very easily without any penalty (except commissions). See here:
http://www.techuncovered.com/ch26.html

I very much like the idea of moving from one ETF to a very similar and getting a huge tax benefit credit. IVV -> IWB or IJH -> IWR, etc. If you go in for the funds and try the same technique, on top of the 1% penalization, you'd probably pretty hard pressed to have as many options that are similar as with ETFs. Lots of Large Blend options to consider, lots of small, lots of foreign that are just enough different to harvest the tax benefits...

Something to consider!

 

[Newell]

Unless an investor is making frequent, low volume purchases or sales (eg, dollar cost averaging), I can find no reason to use index funds as opposed to ETFs. Are there reasons that I'm overlooking?

 

[cute fuzzy bunny]

Dividend reinvestment could be a frequent, low volume transaction, unless the etf automatically reinvests the dividends.

 

[Nords]

Unless an investor is making frequent, low volume purchases or sales (eg, dollar cost averaging), I can find no reason to use index funds as opposed to ETFs. Are there reasons that I'm overlooking?

Vanguard or Fidelity may have funds with expense ratios lower than the equivalent ETF. (But none come to mind right now.) And the govt's TSP, one of the biggest funds of all, has a small-cap stock index fund with an ER of 0.10 that I'd never find in an ETF.

 

[Newell]

Dividend reinvestment could be a frequent, low volume transaction, unless the etf automatically reinvests the dividends.

Many brokerage firms reinvest dividends at no charge. I'm not sure whether they make money by marking up the price.

As for expense ratios, any ETFs that I use are very close to, or lower, than what I can do with a fund at Vanguard. I seem to recall that Vangurd's total market fund has an expense ratio of .19% and Vanguard's total market ETF an expense ratio of 0.07%.

 

[Olav23]

Vanguard or Fidelity may have funds with expense ratios lower than the equivalent ETF. (But none come to mind right now.) And the govt's TSP, one of the biggest funds of all, has a small-cap stock index fund with an ER of 0.10 that I'd never find in an ETF.

From Vanguard's website:
Vanguard Small-Cap VIPERs VB 0.10%

Vanguard Small-Cap Value VIPERs VBR 0.12%

Vanguard Small-Cap Growth VIPERs VBK 0.12%

Comparing purely based on ER, not performance, VB is certainly there, and the others are very close (2 bps away)

It's the race to the bottom, and the individual investor is winning

 

[cute fuzzy bunny]

Lets also remember that we're talking a few dollars a year at these ER levels. Man do we win.

Its been a little counter productive for me sometimes though. I've caught myself looking at vanguard funds with .37 and .43 ER's and mumbling "I aint paying that much for a muffler"...

 

[Olav23]

Many brokerage firms reinvest dividends at no charge. I'm not sure whether they make money by marking up the price.

As for expense ratios, any ETFs that I use are very close to, or lower, than what I can do with a fund at Vanguard. I seem to recall that Vangurd's total market fund has an expense ratio of .19% and Vanguard's total market ETF an expense ratio of 0.07%.

From an ETF website:

How do index ETFs handle dividends?
Index ETFs handle dividends in different ways. iShares reinvest dividends in the fund when they are paid. Most funds, such as SPY and QQQ, hold dividends in cash-equivalent instruments until a pre-determined distribution, typically at the end of each month or quarter. HOLDRs distribute cash dividends immediately. In any case, whether the fund distributes or reinvests the dividends, this is still a taxable event for the shareholder. [ed- and might or might not be a commission paying event based on cash dividend payment or reinvestment at the ETF level]


And also: (from indexfunds.com)
Dividend reinvestment policy - Excluding HOLDRs, which are grantor trusts, ETFs have two basic structures: management investment company and unit investment trusts. Most ETFs use the management investment company (or open-ended) structure, which allows for immediate reinvestment of dividends. However, some of the earliest and largest ETFs, such as the SPDR Trust (SPY) and Nasdaq-100 "cubes" (QQQ), are unit investment trusts (UITs). UITs are less flexible than their management investment company cousins, but the UIT structure was chosen for the initial ETFs because it was inexpensive and didn't require a board of directors.

The bottom line is that UITs cannot immediately reinvest dividends - this type of structure distributes dividends to shareholders quarterly, which causes minor tracking error. Management investment company ETFs, on the other hand, can immediately reinvest dividends. Immediate reinvestment of dividends causes outperformance in a rising market and underperformance in falling markets.

 

[ats5g]

Instead I thought a better idea might be to immediately allocate this money into ETFs through TD (since commission is only 11$ as opposed to 30$ at vanguard) since its a lump sum. Then, as I accumulate more, I add it to the low cost funds available at TD (a few dreyfus funds, a TD or American S&P fund etc) then when it gets to be a big enough amount, maybe 10k per fund) dump the funds and again move into the lower cost ETFs. (since I def don't want to dollar cost average into an ETF!)

Hi Olav,

The bolded the part that concerns me. In a taxable account, if you're going to DCA into a mutual fund, and then sell the mutual fund to buy an ETF when the balance gets above a certain amount, you could have pent up capital gains in those mutual funds that you'd be realizing by switching to the ETF's. This might work better in a tax deferred account, but that would mean tax efficiency doesn't matter.

See W. Bernstein's The ETF vs. Open-End Index-Fund Shootout.

I also wouldn't be lulled into sleeping on the tax efficiency of ETF's. Some ETF's do, and ETF's probably will continue to, distribute short term and long term capital gains. Granted, these cap gains distributions aren't a lot, and they aren't often, but be forewarned. Vanguard's tax efficient index funds can and probably will distribute some cap gains as well. The only things specifically tax managed are things like Vanguard's tax managed funds, or Bridgeway's Ultra large cap index, or BRSIX, etc.

If I were going to hold a tax inefficient asset class, like small value, small, or large value in a taxable account I think I'd probably lean towards the ETF's. But for large caps and the total market, I think I'd just go with VTSMX or VFINX. Will you really be tax loss harvesting more than once a year? Why rack up the transaction costs?

- Alec

 

[Olav23]

Alec-

You make a very good point. I actually had thought that I would simply do this once a year and the rest of the time hands off. I guess the basic problem is that TD doesn't offer Vanguard as no-transaction fee funds, and its quite a pain to move from Vanguard -> TD -> Vanguard etc.

So its kinda the choice between:

1. Do i wanna move everything to vanguard and lose the option of ETFs in exchange for the lowest cost funds (since there is no way 30$ trades at vanguard won't eat the profit of moving to ETFs)

OR

2. keep it in TD and lose a few basis points with higher fee No transaction fee funds but still kinda cheap. Dreyfus is around .5 expense ratio, TD has a .2 ER SP500 fund etc because I can move into ETFs for 11$ a trade...

You're right that I'd prob cause quite a bit of taxable events moving even once a year, I was just hoping the losses in one fund would offset the gains in the other. Maybe a more prudent strategy is to only sell off the LOSER, (in the mutual fund) and move this lump sum to an ETF as opposed to just a pure "at the end of the year when a fund has > 10k move it to ETFs"

Thanks everyone for the great posts.. You've certainly given me a lot to consider!

 

[sailor]

olav23,
I'm a newbie at this investing stuff, but I do DCA into ETFs.
Just do it less frequently (once every two or three months vs every month).
I park my money in MM account (~3% APR currently) instead of a fund.
When I have $3k I use electronic check to send my money to Scottrade.
It costs me $7 per transaction at Scottrade, so on $3k it works to .23%

 

[Olav23]

Sailor-

Can you explain your motivation? Do you DCA into ETFs instead of say Vanguard funds because of the tax-loss selling benefit or what primarily? .23 isn't much comparatively, but even on a cheap ETF with a .10 expense ratio, that brings you back up to .33 which is probably double or so the similar underlying fund.

To me the risk of sitting on the sidelines and waiting for the money to accumulate into $3k seems more expensive than the transaction costs. I wonder if anyone has done a study on such things. (I think this is called opportunity risk?)

 

[sailor]

Sailor-

Can you explain your motivation? Do you DCA into ETFs instead of say Vanguard funds because of the tax-loss selling benefit or what primarily? .23 isn't much comparatively, but even on a cheap ETF with a .10 expense ratio, that brings you back up to .33 which is probably double or so the similar underlying fund.

it's .33 only the first year. I'm planning to keep it for at least 15 years.
Also to put things in perspective - If I do it every other month I'm spending 6 * $7 = $42 yearly for my ETF purchases (and this is even not counting free trades I still have few)

To me the risk of sitting on the sidelines and waiting for the money to accumulate into $3k seems more expensive than the transaction costs. I wonder if anyone has done a study on such things. (I think this is called opportunity risk?)

Bernstein was quoting somebody doing a related study - lump sum vs. DCA and he came closer to your conclusions - meaning it's typically better to invest as soon as you have the money.
I guess I'm just lazy. I'm still working on my target asset allocation.

 

[Olav23]

Sailor-

Thank you so much for your completely honest explanation. Just wondered where you were coming from as far as how you chose one vs. the other...

I feel like I've grown some type of "investment paralysis" to where I read and read and read but everything I read contradicts something else and instead I just read and read and don't ever ACT!

I think my goal will be to immediately get into the ETFs with the lump sum, and with newly added money begin putting it into lowest cost funds I can find at TD. I too am lazy and this doesn't involve opening a vanguard account or worrying about all the fees assessed for too small balances, etc..

Thanks for the help everyone!
Olav

 

[Mr._johngalt]

Sailor-

Thank you so much for your completely honest explanation. Just wondered where you were coming from as far as how you chose one vs. the other...

I feel like I've grown some type of "investment paralysis" to where I read and read and read but everything I read contradicts something else and instead I just read and read and don't ever ACT!

I think my goal will be to immediately get into the ETFs with the lump sum, and with newly added money begin putting it into lowest cost funds I can find at TD. I too am lazy and this doesn't involve opening a vanguard account or worrying about all the fees assessed for too small balances, etc..

Thanks for the help everyone!
Olav

Stop all that reading and just visit here. You don't need anything else.

JG

 

[qbkatran]

I am a new poster here... I have porfolio that have stocks and mutual funds and I want to try ETF with a few thousand dollars to learn more about it. I already have an account with Fidelity and I don't want to buy Vanguard because Fedelity charge me an arm and a leg for the transaction fee. Is there any Fidelity ETF that you guys recommend me buying. This is part of my learning process, as long as I can preserve principal I am ok with it. If I can make as much as my CD it's a bonus. Thanks for your help.

 

[Olav23]

Fidelity has some very low expense funds available. I believe they just dropped the rates to around .10 or so (very close to the cheapest ETFs). Have you looked into their funds?

 

[qbkatran]

I looked at Fidelity ETFs but I am not very bright so I am not sure what I am looking at? What is bid? I think I'll have to call Fidelity tomorrow to see if they can explain to me. It looks like they'll charge me broker fee like stocks to trade. I am not sure what is the PRO/CON of ETF. Very interesting, I'll keep on researching.