Converting Vanguard Mutual Funds To ETFs

Though I’ve been an indexer for three decades, my religion has been in mutual funds, not ETFs, as I believed mutual funds were superior in six ways.

But Vanguard has now lowered expense ratios for my three core index funds in the ETF share class but not the Admiral Share class mutual funds. Because Vanguard allows tax-free conversions in some funds, I thought I’d convert a small portion of my account before deciding upon a recommendation to others.

Here’s my analysis and decision as to whether I’ll be converting the rest of my portfolio.

Background

Several weeks ago, I wrote about Vanguard lowering the costs of ETFs and asking, is it time to convert? Now Vanguard has done the same to all three of my core index funds.

With lower expense ratios, it was time for me to give it a try. So I took about $36,000 of my Vanguard Total International Stock Index Fund Admiral Share class (VTIAX) with gains and converted it to the ETF share class Vanguard Total International Stock ETF (VXUS).

Wowed By Conversion Process

Understand that my mutual fund was held by Vanguard and the conversion process might be different or even not allowed at other custodians. Even so, I expected the process to take a few weeks.

I called my Vanguard advisor to start the process, as a Vanguard spokesperson notes this conversion is only available by phone at this time.

First, I made sure I had identified the cost basis on my mutual fund so that it would carry over (for covered shares) to the ETF. Then, speaking with my advisor and a Vanguard broker, I gave them the instructions to convert. They made sure I knew this conversion was only one-way, meaning I couldn’t return to VTIAX without selling and paying taxes.

By the very next day, I was able to see a confirmation that had two pleasant surprises, even beyond the speed of the conversion:

• The VXUS shares were purchased at the closing NAV [net asset value] on the day I placed the order, so I didn’t pay a bid/ask spread or premium or discount.
• I was able to purchase fractional shares. I had been told I could only purchase whole number of shares and would end up receiving a little bit of cash and a gain. That might be the case at non-Vanguard custodian.

It took a few days for the ETF shares to show up in my brokerage account and several days for the cost basis to show up with the specific lots ID method I selected. I had an older legacy account, and Vanguard said newer accounts would receive cost basis information sooner.

What I Got

I showed the transaction to Elisabeth Kashner, FactSet's director of ETF research. She confirmed I bought the ETF at NAV and noted VXUS has a median trading premium of 0.16%.

Kashner stated the premium was driven by the 0.23% creation fee, which is the cost of creating new ETF shares. I lowered my expense ratio by 0.02% per year, which, on the $36,000 that I converted, is about $7.20 a year. Not exactly a bundle, but enough to buy me a modest lunch once a year.

And speaking of lunch, this conversion wasn’t a free lunch. That’s because, when I eventually sell it, I’ll pay a premium or discount in addition to bid/ask spreads, which have averaged 0.02%. Over the past year, trades ranged from a discount of 0.24% to a premium of 0.58%.

Will I Convert More?

It’s important to note that Vanguard does not allow tax-free conversions within bond funds such as Vanguard Total Bond.

A Vanguard spokesperson says that’s because mutual funds declare dividends on a daily basis, while their respective ETF share classes each declare on a monthly basis, making conversions incongruent.

Further, there is less of an argument to convert Total Stock Market Index to ETFs, as the savings are only 0.005%, or a quarter of the differential of the Total International Stock Index.

Kashner stated that she was not sure she would advise converting from Admiral Shares to the ETF at this time, because:

• I haven't yet priced out the uncertainty, slippage and hassle factor around dividend reinvestment.
• Current premium could shift to a discount should redemptions overtake creations. In other words, if there's a panic or a bear market, ETF sellers could face discounts at the time of sale.
• Most index investors are not experienced traders, and might make the mistake of using a market order rather than a limit order.
• I believe Vanguard when it says it aims to reduce fees on the Admiral Shares over time. The fee gap could narrow.

My Decision & Advice

I’m with Kashner: still not sold on the economics of converting. I consider it a wash on total international and recommend against doing it for VTI or any fund that has less than a 0.02% fee differential between the mutual fund share class and ETF. Thus I won’t be converting more for now.

Clearly, those who want to own ETFs that typically trade at a premium (like VXUS) might be better off buying the mutual fund share class and converting to ETFs. On a $100,000 purchase, and a 0.16% average premium to NAV, one would save about $160 if they didn’t pay any commissions to buy the mutual fund.

As for profiting using this technique, Vanguard responded: “We review client activity to identify behavior that does not align with that of a long-term investor and, as a result, may restrict activities in a fund or an account to avoid adversely impacting existing investors.”

If you want to convert, confirm all of the facts in this piece are the same for you whether or not you own the mutual fund at Vanguard or another custodian.

Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for AARP and Financial Planning magazine. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.