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MY FINANCIAL ADVISOR has been on a mission to reduce my investment costs. He’s been replacing my low-cost, broad-based index mutual funds with the exchange-traded fund (ETF) version. He believes this will improve my investment returns over the long run.
For instance, if you own Vanguard Total International Stock Index Fund—a mutual fund—you’re currently paying 0.11% in annual expenses. But Vanguard’s ETF alternative charges just 0.08%, equal to a savings of three cents a year for every $100 invested. That might seem small, but my advisor assures me it can translate into significant savings over time.
You purchase mutual funds directly from the fund company involved, with the price set as of the 4 p.m. ET market close, while ETFs can be traded whenever the stock market is open. I believe switching to ETFs is the right thing to do. But I had doubts about how large the savings would turn out to be. It’s hard to imagine saving three cents a year on every $100 can amount to a whole lot of money.
The upshot: Using NerdWallet’s mutual fund fees calculator, I decided to see how higher costs can impact a hypothetical $1 million retirement portfolio that enjoys 9% annual stock returns and 3% bond returns over a 25-year period.
I used Vanguard mutual fund and ETF expense ratios to determine the estimated 25-year cost, basing the calculation on a hypothetical portfolio with the following initial asset allocation: Vanguard Total Stock Market Index 35%, Total Bond Market Index 35%, Total International Stock Index 15% and Total International Bond Index 15%. Thereafter, no further money was added, and the portfolio wasn’t rebalanced.
Result? Check out the accompanying table. Keep in mind that the ETF cost excludes the modest sum you might lose to the bid-ask spread when you buy or sell an ETF. What can we learn from the table?
Dennis Friedman retired from Boeing Satellite Systems after a 30-year career in manufacturing. Born in Ohio, Dennis is a California transplant with a bachelor’s degree in history and an MBA. A self-described “humble investor,” he likes reading historical novels and about personal finance. His previous articles include 11 Remodeling Tips, Trust but Verify and No Vacation. Follow Dennis on Twitter @DMFrie.
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Jonathan Clements has identified three disadvantages of ETFs over mutual funds: getting a suboptimal price per share due to trade execution issues, bid-ask spread, premium/discount from the NAV. These disadvantages represent costs that one incurs when using an ETF share class instead of a mutual fund share class.
An investor incurs these costs when he or she makes the initial investment and also when he or she eventually sells the investment. Further, an investor incurs these costs on an ongoing basis as part of rebalancing transactions.
Given these myriad costs associated with ETFs, is it worthwhile to use an ETF share class instead of a traditional mutual fund share class despite the lower expense ratio for the ETF share class? We are frequently told that “there is no free lunch” in investing except for diversification and rebalancing. Is it possible that the lower expense ratio of ETFs is not a ‘free lunch’? Thanks for your response.
Doesn’t the advisor fee negate any fee savings using ETFs? In just seven years it appears. It’s like I have any idea to save you $20,000 over 25 years, but it will cost you $75,000 to learn what it is. What is the other advice value?
If Dennis stuck with the higher-cost index mutual funds, rather than swapping to the ETFs, he’d still be paying for the advisor, so the cost of the advisor is immaterial to the choice.
Something else to keep in mind, that I’ve noticed about switching from funds to ETFs: The mutual funds I owned automatically reinvested their dividend share when it’s paid out, whereas ETF’s pay dividends directly to your brokerage account. This can be a good thing or an annoyance, depending on your needs and point of view. For me, I don’t mind this, as it’s a way to generate a stream of steady income in the face of today’s paltry bond yields, without incurring the rather large inflation risk of, say, 10-year bonds with a .7% (or lower!) yield.
I can’t say whether all corresponding mutual fund to ETF counterparts work this way, maybe some of the other commenters here can chip in some of their experience with this.
If you own an ETF with Vanguard, the dividends are automatically reinvested if you select that option. They are not paid directly to your brokerage account.
Mutual fund distributions may be reinvested automatically and promptly. ETF distributions require explicit action by the investor to reinvest the distributions, thus resulting in a potential time delay in reinvestment. Is it possible that the prompt reinvestment of mutual fund distributions, which puts ‘money to work’ sooner, compensates for the higher expense ratios of mutual funds, thus rendering the ‘mutual fund vs. ETF’ issue moot? Any opinions?
If you own an ETF with Vanguard, the dividends can be automatically reinvested if you select that option. The dividends for a mutual fund and ETF are treated the same way by Vanguard.
“Vanguard Personal Advisor Services at 0.3%. $3000 on $1,000,000 first year.” I have looked at various advisory services over time. These services seem way over-priced compared to an independent CFP. What am I missing? I have used 3 different CFPs over 50 years. The most I ever paid in one year was less than $3000. That was for a complete financial review, forecasting, and portfolio recommendations. Many, but not all years, I pay for a quick rebalance. That’s maybe $500. If I have easy one off questions during the year my CFP will provide a recommendation at no cost. If the question requires time to respond I am charged on an hourly basis. So what is it I don’t get? These services at .3% or whatever seem like too high a cost for a person’s everyday portfolio.
Interesting and informative article. I went on the Vanguard website and learned that if you own Vanguard mutual funds that have an ETF class, you can generally convert from the fund class to the ETF class, and it’s not a taxable event. However, the Vanguard ETF FAQ states that there are several Vanguard bond funds that don’t allow conversions. They are Total Bond Market, Short-Term Bond, Intermediate-Term Bond, and Long-Term Bond. Of course, if you hold one of those funds in an IRA, you can still make the exchange but you would have to consider the tax consequences if you have an unrealized gain currently. Anyway, thank you for this article, I may do some conversions of some of my Vanguard funds to their ETF class.
Thanks, Dennis for mentioning the Nerd Wallet calculator. Like others, I discussed converting Vanguard mutual funds to ETFs with a Vanguard advisor. After opening a Vanguard brokerage account, I did more research on my Vanguard holdings:
o only 1/2 of my funds had ETFs
o one fund’s expense ratio was the same as the ETF
o 2 other funds had an expense ratio difference of 0.02
o one fund’s expense ratio difference was 0.17
I used the fund’s performance ratio’s for the past 10 years to calculate the difference in returns over 10 years using the Nerd Wallet calculator. I found that the difference for most funds was inconsequential; the fund with the greatest difference (0.17) is significant enough to warrant converting it to an ETF, assuming Vanguard does not lower its expense ratio. Vanguard has been lowering expense ratios on its funds, including Admiral funds.
I read where Vanguard Personal Advisory Service believes they can even help make up the difference in their .3% fee through the value they provide. I recently was reading about returns some years back and the only asset class that was positive that year the writer wrote was international bonds. I never had international bonds before I had an advisor. An advisor can not only help someone with asset allocation, rebalancing, tax loss harvesting and host of other services but also act as a coach when one might be tempted to make a timing move that might have a negative outcome. I’m with Dennis the value of an advisor might be for everyone but it helps me sleep better and focus on other areas of my life.
You mentioned in your article that you did not include the bid-ask spread in your analysis. I checked the bid-ask spreads for these funds on Yahoo: 35bps (VTI); 53bps (BND); 55bps (BNDX); and a whopping 182bps for (VXUS). Incorporating this into your analysis will effect the outcome of your costs. Of course, you only pay the bid-ask spread when you buy and sell, but it is likely that you may want to rebalance on an annual, or more frequent, basis.
Also, when you buy and sell through a broker (eg, Schwab, Fidelity, etc.) you typically do not get the quoted bid or asking price. Instead you get executed wide of the the market quote, which further adds to your costs. This also assumes that you do not have to pay any trading commissions.
In my opinion, EFTs are great when it is impractical for other reasons to hold the index fund directly though Vanguard. For example, your employer has bad investment choices in your 401k, but you have a brokerage option within the company’s plan.
Another great tool that provides additional information along with a graph is from Canadian book author Larry Bates “Beat The Bank” with his T-Rex Score tool.
https://larrybates.ca/t-rex-score/