(PUB) Investing 2016

INVESTMENT VEHICLES Funds for Investors. ETFs for Traders.

Yup, the old, tried-and-true open-end fund is probably just as good as the ETF, if not better, when it comes to taxes. (For an in-depth review of Vanguard’s funds’ tax efficiency, see the May and June 2016 issues of the newsletter.) Let’s look at the third pillar: trans- parency. ETFs have to disclose the stocks in their portfolio every single day, whereas mutual funds only have to update their holdings every quarter— making ETFs more transparent, right? Well, first, remember that at Vanguard ETFs are simply another share class of its index mutual funds, so they own the same basket of stocks, and hence one can’t be more transparent than the other. But putting that aside, updating hold- ings daily only increases transparency if those holdings are actually changing each day. While an active portfolio manager may buy a stock one day that he or she didn’t own the day before or even completely rejigger a fund’s portfolio, indexes (and index funds) don’t work that way. Most indexes only reconstitute their portfolios, a process of reviewing and changing their hold- ings if necessary, once a quarter or once a year. So for an index-tracking portfo- lio, whether a mutual fund or ETF, the holdings simply aren’t changing day to day or even week to week. Which brings us to that fourth and final selling point: liquidity, the ability to easily buy or sell an asset any time the markets are open. Stocks trade all day long and, hence, are very liquid. Your house, on the other hand, is not liquid, as it would take several weeks to sell in even an optimal scenario. Because ETFs can be traded throughout the day, they are more liquid than mutual funds, which only trade at one price, their net-asset value, at the end of the day. ETFs also offer more trading flexibility in terms of setting stop-loss orders or short-selling—things you can’t do with a mutual fund. (Though, I seriously question whether most investors should be engaged in either market-timing or

MUTUAL FUND, or exchange-traded fund (ETF)—which is better? The com- mon assumption behind that question is that ETFs, being the newer Wall St. innovation, must be superior to the stodgy old mutual fund that our parents and grandparents invest in. But don’t count out the old fash- ioned mutual fund just yet. I’ll go through the pros and cons in a minute, but let’s start at the beginning. ETFs, like index mutual funds, provide an easy way to buy a predetermined basket of stocks or bonds. In the simplest terms, an ETF is just an index fund. What sets ETFs apart is that they trade through- out the day, like a stock, as opposed to mutual funds, which are priced just once a day at the market’s close. The first ETF launched in the U.S., in 1993, was State Street’s SPDR S&P 500 ETF (SPY). Though ETFs have taken off since then, they weren’t an overnight success. It took nearly two and a half years for the second ETF, State Street’s MidCap SPDR (MDY), to hit the market. ETFs holding foreign stocks didn’t arrive until 1996. Seven years after SPY’s inception, there were only 30 ETFs in the U.S., and Vanguard didn’t enter the market until 2001. The first bond ETFs came on the scene in 2002, and commodity ETFs landed in 2004. Since then, the ETF industry has exploded. In 2008, ETFs held a combined $531 billion in assets. Today, there are nearly 2,000 ETFs available in the U.S., and assets invested via ETFs sit just shy of $2.4 trillion. Clearly something is drawing the attention and dollars of investors and traders. ETFs, like shiny new toys, are con- sidered superior to old-school mutual funds. And that superiority is gener- ally built on the foundation of four pil- lars: low cost, tax-efficiency, transpar- ency and liquidity. But are these pillars unique to ETFs, or do mutual funds share those qualities? And if they are shared qualities, are ETFs still better? Let’s take costs first. Are ETFs really

Vanguard’s 500 Index Share Classes

Minimum Investment

Expense Ratio

Share Class

500 Index

$3,000 0.16% $10,000 0.05% None 0.05%

Admiral 500 Index S&P 500 ETF Inst. Index Inst.

cheaper than index mutual funds? First, it’s important to make sure you’re com- paring index funds and ETFs with simi- lar, if not identical, investment objec- tives. At Vanguard, for instance, where many index funds offer an ETF share class that tracks the exact same index benchmark, the lower-cost Admiral shares of its mutual funds operate with- in one basis point (0.01%) or less of the ETF shares. So, if you can meet the minimum for the Admiral shares (typically $10,000) then, from a cost perspective, the ETF has no advantage over the mutual fund, and vice versa. As you can see in the table above, different share classes of Vanguard’s classic 500 Index operate with varying expenses depending on how much you have to invest. Only the original Investor shares of the fund are more “expensive” than the ETF shares. Okay. Number two. In theory, ETFs should be more tax-efficient than mutu- al funds. In practice, though, index mutual funds are already extremely tax-efficient, and, at least at Vanguard, it is a toss-up which will leave you with more money after taxes are paid. When I matched up 36 ETFs with their Investor share siblings and com- pared after-tax returns over the past five years, in half of the instances the ETF shares led—which means that in half the comparisons the index mutual fund outperformed after taxes. And that’s using the most expensive share class of Vanguard’s index mutual funds. Use a cheaper share class, and the balance tips toward the fund over the ETF. $5,000,000 0.04% Inst. Index Inst. Plus $200,000,000 0.02% 500 Index Inst. Select $5,000,000,000 0.01%

6 • Fund Family Shareholder Association

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