An alternative to using mutual funds to split up my asset allocations is using ETFs. One of the perks of ETFs is that they often have lower expense ratios than similar mutual funds. An example is the Vanguard Total Stock Market Index Fund (VTSMX) vs. Vanguard Total Stock Market VIPERs (VTI). Both track the MSCI US Broad Market Index, but VTSMX has an expense ratio of 0.19% vs. VTI’s 0.07%. But, since I plan on dollar-cost-averaging, I must also consider transaction costs. If you meet the minimums, it costs nothing to buy VTSMX in a Vanguard account. But every time you buy VTI, you have to pay stock commissions.
The Motley Fool recommends that you keep your commission cost below 2% of your invested principle. I personally like to keep it under 1%. This means if you are paying $5 a trade, you should be buying at least $500 of shares at a time. Otherwise the stock will have to gain more than 1% just for you to break even.
I look at it this way. If I buy $500 of VTI for $5, I just paid a 1% upfront expense. Given that VTI has a lower expense ratio than VTSMX by .12%, I will have to keep VTI for years before I break-even expense-wise. But sooner or later I will break even and start saving money since I plan on holding them indefinitely. Hmm.
Of course, there are other advantages to ETFs like their tax-efficiency and midday trading ability. Also, when I eventually sell I’ll be hit with a commission again, but hopefully by then they will have grown so much it will be a much smaller percentage. (Maybe stock trades will be even cheaper by then too.)
Now I must try to find some cheap ETFs for other asset groups. For example IWM, which tracks the Russell 2000 Small-Cap Index has an expense ratio of 0.20%, while Vanguard’s Small-Cap Index Fund NAESX is only a bit higher at 0.23%. That may not be enough savings to make it worth the trouble.
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I’m in the process of rolling my 401(k) into Vanguard, with the intention of recharacterizing it to a Roth. I had a hard time choosing whether to put it in Scottrade (with my existing Roth) or send it to Vanguard. In the end, I chose Vanguard b/c I feel that one of the most important factors to long term succes is annual rebalancing. To do this in an ETF based portfolio could be very costly. I could see it being easier to rebalance in a taxable portfolio, since, if you have the cash on hand, you can just buy the ETF necessary to bring them up to certain levels. However, in a Roth, you could be limited by the annual contribution limits if you took this approach.
….oh well, I hope things turn out well in the long run.
ETF’s have a slight advantage for taxable accounts. When it comes time to rebalance you have to sell some of your winners to buy the losers, right? With ETF’s you can sell your loser for a cap gain loss and buy an ETF in the same category (subject to limits, but of course you can carry forward).
I do ETF’s in my portfolio because we have sizable taxable and non-taxable retirement accounts that we treat as “one” retirement account – no reason to duplicate securities & commissions across accounts.
-Wes
ETFs are not good for Roth. If you want to keep expense around 1%, you can only spend up to $40 for the commission as the current cap is $4,000 annually. In the end, you can only purchase up to, say, 4 funds? Plus, you can only buy it once (lump-sum, no choice of dollar-averaging).
ShareBuilder may be the only option as it takes $12 for 6 trades and $20 for 20 trades a month.
Do you mind giving a cut and dry basic explanation of what an expense ratio is and how it affects the funds you are talking about?
I was really thinking about doing the ETF’s but then I did some comparison. I got a lot of funds at Schwab now (I closed all my bank accounts years ago and have only been using their Schwab One account, it has free checking and the balances earn interest). To sell them for the non-IRA accounts I would have to recognize the capital gains, etc. Also, each trade I think they’re charging $19.95 for ETF’s, where as the mutual funds there’s no transaction charge. I also have a Vanguard 500 Index account, to sell that would also bring a tax bill for the capital gains as well, plus the brokerage fees. So do you think it’s worth it to go ETF in my case?
I have $3k to invest in a Roth IRA for 2005. I need to contribute before April 15th, and I have no IRAs from the past, so I’m totally new at this. I hear from just about every blog out there that Vanguard is the place to start, but I’m not sure what to do beyond that. Can I invest in index funds for a Roth IRA? I hear those are better in the long run than mutal funds. I’m trying to do something that has the least amount of expenses as possible. Any tips?
Expense ratio is how much a Mutual funds or Exchange Traded funds charge their customers(you) each year for doing business. For example, if you invest 10k, you will pay $100 a year to the mutual fund if the expense ratio is at 1%. They take out their fees before distributing dividends or capital gains, so some people don’t know.
I’d try to keep commission cost well below .5% if possible. But commission is a variable cost and if should not be worried about too much if you keep costs low in the first place.
1. To the gentleman starting with his first ROTH IRA. I recommend depositing the money into a ROTH IRA account first – before April 15. Vanguard, Fidelity and Schwab are good options. Once your money is in you can research and take your time.
Since you’re just starting, you may find that many mutual funds require certain investment minimums, which might mean you could only afford a small number of funds.
I think the same arguement that West mentioned with ETFs also applies to mutual funds. Good point, Wes.
Ideally, your investment should be diversified into different types of investments.
Most of the life cycle funds will do that.
I’m most familiar with Schwab’s and Fidelity’s. Both seem to be good and perform well.
All you need to do is select a fund that is near your retirement date. If you plan to retire in 2035, pick the 2035 fund.
Also, most of the brokerage sites have tools that will automatically recommend different combinations of funds.
In your case I recommend a lifecycle fund, as it will act as a big basket of different types of funds. Also, as you age, it will automatically reapportion your investments from risky to less risky.
As to ETFs, they make better sense in a taxable account than a tax deffered account like a Roth. First, see if you have any retirement options at work, like a 401k with a match. Second, if you can, max out a roth. Third, see if you can put money into an IRA – it may not be tax deductable, but it will grow tax deferred, which is a benefit.
Chris, you make a good point about commissions and switching investments in taxable accounts. Selling your mutual funds might put you in a capital gains situation. Maybe you can consider future investments for ETF and keep what you have now – after all, it may be working well for you. As to commissions, Consumer Reports rated First Trade (www.firstrade.com) as one of it’s best values. They only charge $6.95 for equity trades (including ETFs).
Not so fast. Don’t assume that ETF’s are more tax efficient than a traditional mutual index fund (or perform better because of lower costs, see my next post)
Per Morningstar article dated 2/14/06:
“As tax-friendly as ETFs are, it also pays to compare their records with similar conventional mutual fund competitors. For instance, Vanguard 500 Index’s VFINX tax-cost ratios for the trailing one-, three-, and five-year periods ended Jan. 31, 2006, are lower than those of both of its ETF rivals: SPDR SPY and iShares S&P 500 Index IVV. That means Vanguard shareholders lost less of their returns to taxes than investors in the ETFs.
Vanguard 500’s actual aftertax returns (assuming an investor doesn’t sell the fund at the end of the time period) also are better than its exchange-traded rivals’. Similarly, at the end of January, the five-year tax-cost ratios and tax-adjusted returns of traditional index funds such as the Schwab 1000 Index SNXFX and the TIAA-CREF Equity Index TCEIX were better than those of their ETF counterparts– iShares Russell 1000 Index IWB and iShares Russell 3000 Index IWV, respectively. This shows traditional fund managers who pay attention to taxes–for example, by assiduously harvesting losses to offset gains–can be more than competitive with ETFs. “
I opened my Roth IRA with fidility (thanks to all the info on this blog !!!).
Q1) How many days does it take to setup money line with fidility to my checking account?
Q2) Any openion on “Fidelity Spartan 500 Index Investor (FSMKX)” fund for my $4000/- roth ? cost, growth, fee? This is the only account i have with Fidility which i am planning to fund $4000/- before April 15th. I do not want to get slammed with any hidden fee or costs.
If I am maxing out my 401 K contributions…and I want to invest more..should I put the money in a non-tax deductible IRA (limit $4K) or should I simply invest it in a stock or mutual fund? At my current income rate…I do not see the advantage of the IRA. Any ideas???