Wednesday, November 22, 2017

Vanguard's Comprehensive Range of Mutual Funds and ETFs: A Specialized Comparison

I consider myself a passive investor, and my investment portfolio primarily consists of Vanguard's low-cost funds and ETFs. Vanguard offers a wide array of high-quality fund and ETF options, which has been instrumental in shaping my investment strategy. One of the initial decisions I confronted was whether to opt for ETFs or mutual funds. The internet is teeming with abundant resources, providing extensive insights into the advantages and disadvantages of both these investment vehicles. This decision marked a pivotal moment in my investment journey, as it influenced the structure of my portfolio and how I approach passive investing. Vanguard's diverse offerings have empowered me to tailor my investment approach to suit my financial objectives, and their low-cost nature aligns perfectly with my passive investment philosophy. The choice between ETFs and mutual funds represents a critical aspect of my investment strategy, underscoring the importance of thorough research and due diligence when crafting a portfolio that suits my long-term goals.


In this article, I delve into a comprehensive examination of mutual funds and ETFs, but with a distinctive focus on Vanguard's offerings. While there are numerous resources available for comparing these investment vehicles, my approach centers exclusively on Vanguard's extensive range of funds and ETFs. Vanguard is among the select few investment companies that boast such a wide spectrum of both ETFs and mutual funds in their lineup. Other prominent firms, such as Fidelity and Schwab, do come to mind as competitors in this regard. Furthermore, it's noteworthy that all my investment transactions are conducted exclusively through my Vanguard brokerage account. This platform grants me the advantage of commission-free trading for both Vanguard ETFs and funds, making it a cost-effective and efficient choice for managing my investment portfolio. Thus, my exploration of mutual funds and ETFs within this context provides a specialized perspective tailored to Vanguard's offerings and my preferred investment environment.

Choices:
This represents a crucial and unalterable constraint with no available workarounds. It's essential to recognize that not all ETFs possess corresponding counterparts in the form of mutual funds, and vice versa. Generally, nearly all index funds offer an ETF variation, while a majority of actively managed funds lack an ETF equivalent. Consequently, your choice of investment strategy may limit you to just one category. For instance, take Vanguard's Wellington Fund (VWELX), the oldest mutual fund in Vanguard's repertoire and the nation's oldest balanced fund, initiated in 1929. Regrettably, this fund isn't accessible in ETF form. Conversely, Vanguard Mega Cap Growth (MGK) exclusively exists as an ETF. Additionally, it's worth noting that the vast majority of sector ETFs have no corresponding mutual fund alternatives.


Minimum Investment:
For individuals embarking on their investment journey, this factor unquestionably bears significant importance. Vanguard's investor-class funds typically necessitate a minimum investment of $3,000, while admiral-class funds set a higher bar at $10,000. The key distinction between these two classes lies in their expense ratios, which I will delve into further. In contrast, ETFs present a more flexible option. Owning them merely requires the financial capacity to purchase a single share. Nevertheless, it's important to note that if you choose to trade ETFs outside of Vanguard, you may still incur trading commissions, such as the $6.95 fee on TD Ameritrade. However, platforms like Robinhood may offer commission-free trading for ETFs. Occasionally, admiral-class versions of funds, particularly those that are actively managed, may demand substantially larger minimum investments, ranging from $50,000 to even $100,000 in the case of sector funds. In my initial investment journey, I adopted a combination of investor shares and ETFs. My approach hinged on the expense ratio – if it dipped below 0.20%, I found mutual funds acceptable; otherwise, I gravitated toward ETFs, provided they were available. To illustrate, consider Vanguard's Emerging Markets Stock Index Fund (VEIEX), which sports an expense ratio of 0.32%. Although it registers as relatively high within Vanguard's spectrum, it remains one of the most cost-effective options in the realm of emerging market funds. In contrast, its ETF counterpart, VWO, boasts a more favorable expense ratio at 0.14%. This cost-conscious approach enables me to make informed decisions about the investment vehicles I select, ensuring optimal value in my portfolio.


Expense Ratio:
Vanguard offers its funds in three distinct variants: investor-class, admiral-class, and institutional-class. It's noteworthy that institutional-class funds, such as VINIX, require a minimum investment threshold of $5,000,000, which is typically associated with 401k investments. Given this substantial minimum, we won't delve into the institutional-class funds in this discussion. Within the realm of investor-class, admiral-class, and ETF variants, there are distinctions in expense ratios. Investor shares generally exhibit the highest expense ratios among these options. Interestingly, the ETF and admiral funds share the same expense ratio. Investor shares tend to be more frequently bought and sold compared to admiral shares. Such trading activity generates costs for all fund investors. To offset these costs, investor shares typically bear a higher expense ratio. However, it's worth noting that the assets under management (AUM) for ETFs are considerably lower than those for investor and admiral shares. This variance in AUM may influence the cost structure, potentially making the selling of ETFs a more cost-efficient option for all fund shareholders.


Automated Investing:
Setting up automatic investments with mutual funds is a viable option. The pricing of a single unit of a mutual fund is determined at the close of the trading day, typically at 4:00 PM Eastern Time. All investment orders are executed after this daily evaluation. Vanguard funds, for instance, generally provide their values around 6 PM Eastern Time. One notable advantage of a Vanguard brokerage account is that it offers commission-free transactions for both mutual funds and ETFs. In the case of mutual funds, you have the flexibility to automate investments with amounts as low as $25. However, the approach differs when dealing with ETFs. ETFs are traded like individual stocks, which means automated orders cannot be placed for them. ETF prices fluctuate throughout the trading day, and in some instances, the ETF's price may surpass the combined value of the underlying stocks it holds, resulting in a premium to net asset value (NAV). In my investment strategy, automatic monthly contributions are allocated to mutual funds based on my predetermined asset allocation. Conversely, ETFs require manual execution, and I initiate these transactions on a monthly basis when I have accumulated sufficient capital to purchase a single share. This method allows for a more hands-on approach to ETF investments due to their trading characteristics.


Dollar Cost Averaging:

Auto investing offers a significant benefit known as dollar cost averaging (DCA), a valuable strategy that allows me to periodically balance out both losses and gains in mutual funds. This approach proves especially advantageous when coupled with passive investing. The combination of passive investment and DCA presents a compelling reason for consideration. However, when it comes to DCA with ETFs, the effectiveness may vary, especially if you do not have a Vanguard or Robinhood brokerage account. In other brokerage accounts, transaction fees can accumulate quickly and erode the benefits of DCA. One possible workaround to mitigate these fees is to accumulate a substantial capital base, such as $1,000, before executing a purchase. While this approach helps reduce the time your capital is in the market and lowers transaction frequency, it may also diminish the effectiveness of DCA in smoothing out investment fluctuations. In essence, DCA remains a powerful strategy, particularly when applied to passive investing with mutual funds. However, the cost dynamics of DCA differ when dealing with ETFs, highlighting the importance of selecting an appropriate brokerage account and considering the trade-offs between capital accumulation and DCA effectiveness.


Cost (Trading):

As previously mentioned, trading Vanguard mutual funds and ETFs incurs no fees when using a Vanguard brokerage account. It's important to note that while the Vanguard brokerage platform may not offer advanced order types like trailing stop orders, it more than suffices for investing in passive funds and ETFs. While it may not be considered a top-tier trading platform, it serves its primary purpose effectively. In contrast, I explored the trading commissions associated with a TD Ameritrade account, which I happen to possess. The costs for trading mutual funds on this platform are surprisingly high, standing at $49.99 per trade – a significant expense. ETFs, on the other hand, are treated like stocks, incurring a $6.95 fee per trade. For individuals who do not possess a Vanguard brokerage account, trading ETFs may potentially offer a more cost-effective alternative, especially when compared to the steep fees associated with mutual funds on platforms like TD Ameritrade. It's worth noting that for those who prefer commission-free trading, platforms like Robinhood offer ETF trading without incurring any fees.


Purchase & Redemption Fee:
Occasionally, newly launched funds may impose purchase and redemption fees. The primary aim behind these fees is to alleviate the cost burden on all fund investors. The constant buying and selling of fund shares can significantly raise costs, and purchase and redemption fees serve as a mechanism to mitigate excessive turnover. It's important to note that these fees generally do not apply to the ETF version of funds, possibly because the assets under management (AUM) are insufficient to exert a notable impact on overall expenses. Once these newly established funds have reached a stable state, any additional fees are typically rescinded. For instance, take Vanguard International Dividend Appreciation Index Fund (VIAIX), which levies a purchase fee of 0.25% and a redemption fee of 0.25% in addition to an expense ratio of 0.35%. In contrast, its ETF counterpart, VIGI, does not impose any purchase or redemption fees and boasts a lower expense ratio of 0.25%. This distinction illustrates how these fees are employed to manage costs during the initial phase of a fund's launch and are eventually removed once the fund achieves stability.


Dividend Reinvestment (DRIP):
When it comes to dividend reinvestment (DRIP), there is virtually no distinction between mutual funds and ETFs. Both facilitate the reinvestment of dividends, and it's also feasible to acquire fractional shares of ETFs through DRIP.


Fractional Shares:
The purchase of fractional shares in Vanguard ETFs is currently not an option, but it is entirely feasible to acquire fractional units of Vanguard mutual funds. For my investment strategy, the ability to buy fractional shares aligns seamlessly with my auto-investing and dollar-cost averaging approach. To illustrate, suppose I have $25 available for investment in November. With this amount, I can purchase 0.104 fractional units of VFINX. In contrast, acquiring a single share of VOO would require an investment of approximately $238. It's important to note that this calculation assumes I've already committed $3,000 to establish a position in VFINX. Fractional shares provide a level of flexibility that accommodates investors with varying capital levels, making it easier to engage in dollar-cost averaging and gradual portfolio building.


Options & Shorting:
ETFs share similar characteristics with stocks and can be utilized for option trading. For instance, the option chain for the Vanguard S&P 500 ETF (VOO) demonstrates the possibilities. A common approach to generating additional income is to engage in the strategy of selling covered calls, which could align with the buy-and-hold approach typically associated with owning these ETFs. It's worth mentioning that, while these strategies are available, I don't personally employ them, as I am not an expert in either covered calls or option trading. Moreover, ETFs also provide the opportunity for shorting, as demonstrated by the short interest data available for VOO. It's important to acknowledge that a popular ETF like VOO tends to witness a significant volume of option-related and shorting activities. In contrast, ETFs with lower levels of trading activity, such as VIG, may experience fewer instances of such actions.


Conversion:
Converting a mutual fund into an ETF is a seamless process, and importantly, it is a non-taxable event. To initiate this transformation, a direct call to Vanguard is required. On the flip side, converting an ETF back into a mutual fund is not feasible. In this case, the sole option is to sell the ETF, which entails a taxable event, and subsequently utilize the proceeds to purchase a mutual fund. This means that while converting from mutual funds to ETFs offers a tax-efficient transition, the reverse journey from ETFs to mutual funds involves realizing capital gains and potential tax implications.


Selling (Hold):
When selling mutual funds, there is typically a one-month hold imposed on subsequent purchases, a measure implemented to minimize costs for all fund investors. In contrast, ETFs do not carry such restrictions, allowing for more immediate and flexible buying and selling actions.


Dividend Yield:
Lastly, it's worth noting that the yield of ETFs often tends to be higher than that of investor shares, while the yield for admiral shares and ETFs remains the same. This difference in yield is primarily attributed to the fund expenses (expense ratio or ER) which are typically deducted from the dividends distributed to investors. Given that the expense ratio for investor shares is higher than that of ETFs, it naturally results in a lower yield for investor shares. For instance, consider the Vanguard 500 Index Fund (Investor) which boasts an effective yield of 1.82% after accounting for expenses. This implies that its yield prior to accounting for the expense ratio was 1.96% (1.96% - 0.14% ER = 1.82%). Similarly, the Vanguard S&P 500 ETF has an effective yield of 1.92%, suggesting that its initial yield before accounting for expenses was also 1.96% (1.96% - 0.04% ER = 1.92%). The difference in yield, which stands at 0.10% (1.92% - 1.82%), essentially mirrors the difference in expense ratio, amounting to 0.10% (0.14% - 0.10%). This differential underscores how the varying expense ratios directly impact the yields of different fund share classes.









27 comments:

  1. Very nice, thorough summary. To me, I really only consider two things when debating ETFs or mutual funds. What are the fees/expense ratio and does the fund meet my investing objectives. As you mentioned above, sometimes there are not comparable ETFs and mutual funds. So if you are trying to achieve one objective with the investment, you may be stuck.

    Happy Thanksgiving!

    Bert

    ReplyDelete
    Replies
    1. Happy Thanksgiving Bert! Actively managed funds seem to be missing ETFs. Thanks mate!.

      Delete
  2. Hi DG, Excellent analysis on the pros and cons. I think both funds and ETFs can have a role in a diversified portfolio and I do own both. The fees on actively managed mutual funds do bother me since it is so important to keep investment costs low in order to maximize returns. Tom

    ReplyDelete
    Replies
    1. True mate! My portfolio is a combination of funds and ETFs too. I own VGHCX, which is actively managed.

      Delete
  3. Nice summary! I own Vanguard ETFs in my 529 plan. I've switched entirely to investing in individual stocks in my personal portfolio. I'm with Schwab though so do have access to the excellent selection of low cost ETFs that they offer (in addition to Vanguard ETFs). I do need some more exposure to emerging and international markets so might invest in ETFs there to get more diversified exposure to a sector that I'm not as familiar with.

    Scott

    ReplyDelete
    Replies
    1. Schwab has some awesome ETFs. I don't want to slice and dice too much, but have some international exposure is good. Check out VXUS or VWO.

      Delete
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