Wednesday, May 5, 2010

Vanguard Offers Commission-Free ETF Trades

As of May 4, Vanguard is offering commission-free trades of its 46 Exchange Traded Funds (ETFs), and has lowered brokerage commissions on purchases of other stock and ETFs to $7 per trade (and even less if you have $50,000 or more with Vanguard). I’m thrilled to see this, as it makes them competitive with Schwab and Fidelity in terms of ETF trading costs. It’s now feasible for a small investor to create a low cost, highly diversified portfolio using Vanguard ETFs.

Prior to this, I was recommending that smaller investors use Schwab, and also was recommending using Schwab to get low expense access to a couple of asset classes using its ETFs; e.g., small-cap international and emerging markets. With the new Vanguard deal, I’d recommend that all but the smallest investors (with less than a few thousand dollars to invest) seriously consider using Vanguard Brokerage Services for investing in ETFs.

With its 46 ETFs, Vanguard offers more commission-free ETFs than Fidelity (25) or Schwab (6), and provides access to more asset classes, including a number of bond ETFs, and a REIT (Real Estate Investment Trust) ETF.

Why Use ETFs Instead of Mutual Funds?

If you want to keep things simple, including your asset allocation, then I’d recommend sticking with low-cost index mutual funds. However, using ETFs could lower your long-term costs, and allow you to make smaller investments in certain asset classes (assuming you want to use a more complex asset allocation). For example, if you want to invest in small-cap international stocks, you can invest as little as about $25 at Schwab or about $80 at Vanguard using ETFs, with expense ratios of 0.35% and 0.40% respectively. By contrast, the minimum investment in the international small-cap index mutual fund at Vanguard is $3,000, the expense ratio is 0.63%, and there’s a 0.75% fee to buy or sell shares.

To be fair, there are other transaction costs involved in buying and selling ETFs, even if commission-free. There’s a bid/ask spread, which means that you’ll pay a bit more to buy shares than to sell them. There also will be a premium or discount to the underlying value of the stocks owned by the ETF, and you won’t know what it is when you buy or sell. However, if you plan to hold your ETF shares long-term, these costs are of little concern.

Another caution about ETFs is that the price fluctuates throughout the day, and it’s tempting to get sucked into a trading mentality. For example, I tend to buy ETFs using limit orders, where I specify the price I’m willing to pay. If the ETF share price doesn’t get down to my limit price, I may end up paying more for it at a later date. Trying to get a little bit better price can be stressful and counterproductive, so you may not want to play this game.

Why Schwab Might Still Be Best For the Smallest Investors

Schwab still has some advantages for the smallest investors, e.g., lower minimum to open an account, no annual service fee, and generally lower share prices. The Vanguard minimum to open a brokerage account is $3,000 (although you don’t have to maintain this minimum amount once the account is opened), while at Schwab the minimum to open an account is $1,000, and there are a number of ways to have the minimum waived. Vanguard charges a $20 annual service fee (unless you have at least $50,000 at Vanguard), while Schwab charges no annual service fee. Schwab ETF shares are in the $25-$35 price range, while Vanguard ETF shares are in the $40-$80 price range; the only advantage of a lower share price is that you can make smaller incremental purchases (the minimum purchase of an ETF is the price of one share).

Schwab also offers a few low cost index mutual funds with $100 minimums (compared to $3,000 minimums for Vanguard mutual funds). With a mutual fund (as compared to an ETF), you can make incremental purchases of as little as $1, which is useful if you want to make very small incremental purchases. Mutual funds also are somewhat easier to buy and sell, and have lower trading costs than ETFs, even commission-free; that’s because with an ETF you pay slightly more to buy than to sell (the bid/ask spread). However, ETFs have lower expense ratios, so for the long-term investor, they are likely to have lower overall costs. For the new investor wanting to get started with a few hundred dollars, I still recommend Schwab.

For Everyone Else, Consider Vanguard

If you can afford the $3,000 minimum to open a Vanguard brokerage account, and are willing to deal with the additional complexities of buying ETFs (vs... mutual funds), then you should seriously consider going with a Vanguard brokerage account. The $20 per year account fee does equate to 0.67% of $3,000, which is hefty in the world of low cost ETFs (with expense ratios as low as 0.07%, and with  0.15%-0.25% being typical), but as you grow your account, this fee becomes a smaller percentage of your account value. The breadth of the Vanguard offerings and Vanguard’s expertise in managing index funds is likely to be worth the small additional cost. Also, if you already have a Vanguard mutual fund account, the convenience of using fewer financial institutions makes it even more worth the additional cost of sticking with Vanguard for your brokerage account.

3 comments:

  1. So how about investors who are somewhat in between....if you could start an account at $3000, but will only be making small incremental investments after that...would it be wiser to stay with Vanguard versus spreading your assett classes across companies?

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  2. Kristen, I'd want to know more about the investor before making a recommendation. In your question, you ask about someone "starting an account", so are we talking about someone just starting to invest? If so, then my inclination would be for them to keep things simple at first, and use mutual funds. For a new investor starting with $3,000, and making small incremental contributions, I'd lean toward using the Total Stock and Total International mutual funds at Schwab. The investor could then branch out into using some of the Schwab ETFs for additional asset classes when ready to handle more complexity.

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