Wall Street is throwing a party for mindless speculators. But sober-minded investors may want to stop by.
Make no mistake, the rash of new exchange-traded index funds will live up to their name. Even as overall stock trading shows signs of slowing, folks continue to buy and sell exchange-traded funds like crazy, along the way incurring hefty trading costs and realizing their taxable gains quickly.
But forget this idiocy. Here’s what intrigues me: If you are a long-term investor, are these exchange-traded funds a better alternative to regular index mutual funds?
– Consider the cost. San Francisco’s Barclays Global Investors is in the midst of a three-month rollout of 40 exchange-traded funds, bringing its total offerings to 57. Meanwhile, Vanguard Group, of Malvern, Pa., plans to launch five such funds.
What’s the appeal? If investors buy or sell an exchange-traded fund, they have to go through a broker, rather than directly to the fund itself. That means that exchange-traded funds don’t have the cost of dealing with small investors, so they should have lower expenses than their mutual-fund counterparts.
Suppose you want to buy Standard & Poor’s 500-stock index. You would pay annual expenses of just 0.0945 percent for Barclays’ new iShares S&P 500 Index Fund, compared with 0.18 percent for Vanguard 500 Index Fund, the giant mutual fund.
But exchange-traded funds aren’t always cheaper and annual expenses aren’t the only cost. When you purchase an exchange-traded fund, you also get nicked for a brokerage commission and other trading costs.
These costs are inconsequential if you make a big investment. But if you plan to add, say, $200 a month to your holdings, trading costs would put a big dent in your returns and you would be better off with an index mutual fund.
“The major issue everybody is forgetting is transactional skill,” said William Bernstein, an investment adviser in North Bend, Ore.
He notes, for instance, that Vanguard has been especially adept at managing index funds, sometimes beating the underlying index, even after expenses.
– Paying the piper. Both exchange-traded index funds and index mutual funds can realize capital gains if companies in the index are taken over or dropped from the index. Those gains get passed along to shareholders as taxable distributions.
But index mutual funds face an additional threat, which also may result in taxable distributions. When investors redeem, an index mutual fund could have to sell profitable stock positions to pay off these departing shareholders.
“It’s theoretically possible that you could be forced into realizing capital gains,” concedes Vanguard managing director Gus Sauter. “But from a practical standpoint, it hasn’t happened.”
Still, with an exchange-traded fund, there are no such worries. When small investors sell their fund shares, they have to sell to other investors, just as they would any other stock.
Institutional investors, however, can sell their exchange-traded fund shares back to the fund. But in return, they don’t receive cash. Instead, the fund pays off these institutions by giving them stock held in the fund’s portfolio. Conversely, an institution could hand over a basket of securities and get back fund shares.
This mechanism allows the creation and elimination of fund shares and ensures that a fund’s share price closely tracks its portfolio value.
– Covering your bases. My ideal index portfolio is 75 percent in a broad-based U.S. stock index fund and 25 percent in a foreign stock index fund.
If you built that portfolio at Vanguard using their regular mutual funds, you would pay 0.2 percent in annual expenses to own the Vanguard Total Stock Market Index Fund, which indexes the Wilshire 5000 of most regularly traded U.S. stocks. Meanwhile, for international exposure, you would pay 0.34 percent for the Vanguard Total International Stock Index Fund.
Could you do better with exchange-traded funds? Vanguard won’t say what its new Wilshire 5000 exchange-traded fund will cost. But the iShares Russell 3000 Index Fund and the iShares Dow Jones U.S. Total Market Index Fund, which also will give you broad U.S. market exposure, will both charge annual expenses of 0.2 percent. That is on par with the Vanguard Total Stock Market Index Fund.
So why use the exchange-traded fund? “The difference is going to be the tax efficiency and the trading availability,” says Patricia Dunn, global chief executive of Barclays Global Investors.
While exchange-traded funds seem like a reasonable alternative for U.S. stock exposure, mutual funds remain your best bet in the international arena, at least for now. You could build a global portfolio using the 18 exchange-traded country index funds that Barclays offers. But these funds typically levy 0.84 percent in annual expenses, far more than the Vanguard Total International Stock Index Fund.
