This year I am doing a "Book of the Month" feature on this blog. Besides the standard book review, since I am reviewing books dealing with finances, and since I by no means claim to know everything there is to know about finances, I am going to try to find at least one "Take Action" step in each book--one thing I can do to improve my knowledge, investment or blog. In January, my book of the month was Step by Step Investing and I reviewed it here.
One thing Joseph Hogue talked about was ETFs, which are exchange traded funds. ETFs are the new "in thing" but I've never been able to figure out why they are preferable to mutual funds. This month I decided to review some Vanguard mutual funds and their corresponding ETFs and see what the difference was.
Before I started that project, Janette left this comment on my post: How to Lose Money on Your Investments
My largest loss was a day that I realized the highly respected mutual fund, that had most of our savings, was going down. I put in the sell order immediately. I did not realize that a mutual fund only sells at the end of the day. I lost a LOT of money that day- and had to pay my broker $80 for the transaction.
I realized that by reading Step by Step Investing: A Beginner's Guide to the Best Investments in Stocks I had learned that had Janette's money been in ETFs rather than mutual funds, her sell order would have been executed immediately (however her broker defined that word), rather than at the end of the day. So, presuming the share price was higher when she said "sell" than it was at the end of the day, Janette would have been better off at the end of the day.
How Are Mutual Funds and ETFs Alike?
Both mutual funds and ETFs are baskets of stocks. They can be actively managed with a human (or more likely a team of humans) studying various companies and deciding which ones to buy stock in or they can be index funds where a computer buys and sells stocks to mimic an index of one sort or another. For example, I own shares of Vanguard's Total Stock Market Index Fund which tries to mirror the U.S. stock market as a whole. About 2.4% of the stock market consists of telecommunication companies so about 2.4% of that fund is made of telecommunications companies.
Both ETFs and mutual funds are required to define a style of investing, publicize it and stick with it. If you say you are running a small cap fund (one that buys companies with capitalization below a certain amount) then you don't buy stock in Johnson and Johnson, even if it is the dividend investor's stock of the week.
How are Mutual Funds and ETFs Different?
Let's look at my very simplistic fund. On a per share basis, it is 1/3 X, 1/3 Y and 1/3 Z. Today, X closed at $10 per share but during the day it sold for as high as $12 and as low as $8. Y closed at $20, which was its high point for the day. For much of the day is sold close to $15. Z closed at $5, its lowest point in the day, but there were times during the day when it reached $6.
It just so happens in my perfect simplistic world that at 3:00 p.m. X was selling for $12, Y for $15 and Z for $6. If my fund was an ETF and you bought or sold it at 3:00 p.m, your share price would be $33.00 per share. If you bought or sold at the end of the day, the share price would be $35.00. If my fund was a mutual fund, your cost per share would be $35 because mutual fund shares are only valued and traded at the end of the day.
What Difference Does It Make?
Well, if you are in Janette's position, being in an ETF rather than a mutual fund can make a big difference, for good or for bad. If Janette had been able to sell before the bottom dropped out of the price of her fund, she would have been better off. Of course, if the price of the shares had bounced back up by late afternoon, selling at the end of the day would have been a good thing.
But what about the day to day, for those of us who just invest our money and leave it sit? This chart looks at two Vanguard funds which are available as ETFs, regular mutual fund shares or Admiral mutual fund shares (meaning you have more than $10,000 worth of that fund). You can see that in both cases the Admiral shares and the ETF had similar expense ratios that were noticeably lower than the Investor (regular) shares. From what I could see, there was no minimum investment in the ETFs.
Fund Name
|
Expense Ratio
|
Ten Year Fees on $10,000
|
Ten Year Value of $10,000
|
Vanguard Total Stock Market
|
ETF 0.05
MF 0.16
Admiral 0.05
|
ETF $118
MF $376
Admiral: $118 |
ETF $20,104.24
MF $19,884.58
Admiral: $20,103.24
|
Vanguard Value Index Fund
|
ETF 0.08
MF 0.22
Admiral 0.08
|
ETF $189
MF $516
Admiral $189
|
ETF $17,827.93
MF $17,593.47
Admiral $17,827.25
|
If you had invested in those funds ten years ago, you would have paid the fees listed in the second column and the final column shows the value of today of $10,000 invested ten years ago. It appears that for small accounts, the fees on ETFs are less than the fees on mutual funds with the same assets and management.
Takeaway
We are thinking about investing in another Vanguard Fund, and rather than another mutual fund, it will be an ETF, since the initial investment will be too low for Admiral shares.
"It appears that for small accounts, the fees on ETFs are less than the fees on mutual funds with the same assets and management." Interesting, I didn't realize that. Good information to know!
ReplyDeleteJoseph is an awesome guy (met him at FinCon last year) and he this book shows just how smart he is. A must read for anyone who wants to take their finances serious.
ReplyDeleteThere are a couple of other differences to be aware of. First, the "expense ratio" only includes management expenses. There are also "hidden" expenses, sometimes called transaction costs, and an ETF should have lower hidden costs than the corresponding mutual fund. If you download a Vanguard Annual Report and look at "Your Fund's Performance at a Glance," you'll usually see the ETF outperforms the mutual fund (by about 0.2% in the few that I checked).
ReplyDeleteSecond, mutual funds only trade at the end of the day because they have to do their books each day to set the correct price (equal to the total of all its holdings). An ETF doesn't do this. The buy/sell price of an ETF can deviate quite a bit from the underlying value of the fund. In the case of a market crash, the ETF is likely to trade at a price much lower than it's underlying securities. So, without knowing the details, it's *possible* that Janette would have been no better off in an ETF if she had tried to sell when the market was dropping.