How To Make A Dirt Cheap ETF Even Cheaper

Navigating Vanguard’s share-class maze.

After a seven-blog tour of the robo advisors aimed at helping my son decide how to spend his bar mitzvah money, it’s now time for him to invest. I examined robo investment philosophy, asset allocation, ETF selection and tax-loss harvesting, but my son chose, for now, to buy the Vanguard Total World Stock ETF (VT | B-100).

VT is ETF.com’s “Analyst Pick” among the global total equity market funds, because it offers the broadest, most unbiased, cheapest exposure to the global equity markets. Easy peasy!

Except, actually, it isn’t. My son can get the same exposure for less—within Vanguard.

Easy Tricks

There are two tricks, one obstacle, and a clever backdoor that will allow him to capture 0.30 percent savings. Here’s how.

• Substitute Vanguard Total Stock Market (VTI | A-100) and Vanguard Total International Stock (VXUS | A-99) for VT
• Buy Vanguard’s mutual fund equivalents of VTI and VXUS, VTSAX and VTIAX, respectively

Economies Of Scale

Combining VTI and VXUS creates virtually the same exposure as VT’s, provided you weight each proportionally. As of Sept. 1, 2014, that meant 49.62 percent to VTI and 50.38 percent to VXUS. This brings annual fund fees down to 0.095 percent, versus 0.18 percent for VT.

Say what?

Joel Dickson, Vanguard’s global head of investment research and development, explained that Vanguard passes along economies of scale fund by fund. VT’s $5.7 billion of net assets (all share classes including mutual fund shares and ETF shares) pales beside VTI’s $ 401.2 billion and VXUS’s $133.4 billion, as of Aug. 31, 2014. VTI and VXUS can spread fund expenses across a huge asset base; VT isn’t there yet.

True Holding Costs

These economies of scale show up starkly in real-world holding costs, as revealed by ETF.com’s Analytics’ median annual tracking difference. This metric rolls up costs, like fees and tracking error, along with income such as securities-lending revenues and tax recapture.

As of Sept. 30, 2014, VT underperformed its index by a median 0.24 percent per year. But VTI and VXUS actually outperformed their underlying indexes, by 0.02 and 0.03 percent, respectively. Now that’s operating efficiency.

The VTI/VXUS combo would have saved you 0.265 percent annually over VT, on average, over the past two years.

But you can do even better.

Choosing The Right Share Class

Uniquely among ETF providers, Vanguard issues ETFs as one of many mutual fund share classes. Vanguard’s ETFs contribute to a pooled portfolio. Same fund, same index, same net asset value (NAV), same distributions.

Each share class has its own fees. Vanguard’s ETFs are priced identically to their Admiral shares, which require a minimum investment of $10,000, but are cheaper than the low-minimum Investor shares.

Buy-and-hold investors will get a better deal in the Admiral shares, if they can meet the minimums. Why? Trading costs.

The Hard Realities Of Trading

ETFs trade on exchanges. They come with bid/ask spreads, as well as premium/discount risk. Mutual funds don’t, because they only trade at NAV.

The VTI/VXUS combo carries a weighted median spread of 0.03 percent, as of Sept. 30, 2014. That’s pretty darn good as far as ETF trading spreads go, but it’s not free.

Then there’s the risk of premiums and discounts—market prices that are different from a fund’s NAV.

In September 2014, VXUS’s premiums ranged between 0.09 percent and 0.49 percent, with a one-year median 0.23 percent, based on its closing market price. VTI wavered between a 0.02 percent discount and a 0.04 percent premium.

If you’re lucky, you might be able to buy at a discount and sell at a premium. But you could just as well buy at a premium and sell at a discount, and walk away with less than you would if you had simply bought and sold at NAV. The bottom line is this: Trading away from NAV adds risk.

Little Guys Out In The Cold

Choosing Vanguard’s Admiral shares over ETFs is a no-brainer, if you can meet the $10,000/fund minimum. VTSAX and VTIAX will save you 0.03 percent in spreads, and potentially much more in premium/discount risk, compared with VTI and VXUS.

Folks who can’t pony up $10,000 per fund face higher fees: 0.12 percent extra for VTSMX versus VTI, and 0.08 percent more for VGTSX versus VXUS. That’s 0.10 percent for the pair.

Small investors must decide which is worse: trading costs, or extra fees. It should be a simple breakeven calculation, to figure out how long you have to hold the ETFs until you’ll save enough on fees to cover your trading costs.

For example, we know you can recover the spread costs with four months of lower fees. Alas, you won’t know your full trading costs until you sell your fund, because of premiums and discounts. Let me explain.

Premiums And Discounts

VXUS has traded at a premium, as measured by closing prices, on 94 percent of days since it launched in 2011. The premium varies day by day and trade by trade, but its cause is clear.

VXUS has seen virtually nothing but inflows since the ETF’s debut. Demand has been strong, with natural buyers outnumbering sellers. As sellers of last resort, market makers will offer new shares, but only at a price that covers their costs.

VXUS’ costs are significant. As of Sept. 30, 2014, Vanguard charges fees of $12,000 to create or redeem 100,000 shares. That works out to 0.23 percent per share. If you’re making a market in VXUS, you’ll keep those fees in mind as you jostle for order flow.

If investor sentiment turns, and supply outstrips demand, market makers will become buyers of last resort. They’ll bid below NAV—enough below to cover the redemption fees.

It gets worse. Small investors probably have to trade odd lots. My son’s $6,000 would get him about 30 shares of VTI and 60 of VXUS. Odd-lot traders are price takers. They’re entirely at the mercy of prevailing market conditions.

Nobody can predict future supply or demand. Today’s premia could persist for years, or could disappear tomorrow. You won’t know your net premium/discount costs until you liquidate your position.

If you don’t know your costs, you can’t calculate a breakeven. The best you can do is to be aware of the risks.

The Back Door

There’s a way to avoid half the trading costs and risks, though Vanguard doesn’t publicize it.

Vanguard allows folks to convert mutual fund shares to ETF shares. See VXUS’s Statement of Additional Information (p. B-58) for this unheralded option.

Small investors can buy VTSMX and VGTSX, then immediately convert to VTI and VXUS. They’ll capture the lower fees, and won’t face any trading costs until they sell. Heck, if VTI and VXUS are still trading at a premium, they’ll come out ahead. Brilliant!

Total Savings

Let’s wrap this up:

• Cost savings from swapping VTI/VXUS for VT: 0.265 percent
• Spread costs avoided: 0.03 percent
• Premium/discounts avoided: unknown

My son can save at least 0.295 percent by buying VTSMX and VGTSX, and converting to VTI and VXUS. Sweet!

Better still, I can prove my point: It’s always worth doing your homework.

At the time of this writing, neither the author nor her son owned any of the funds mentioned in this article. Contact Elisabeth Kashner, CFA, at [email protected].