Vanguard ETFs Or Mutual Funds?

Is it time to do tax-free conversions to Vanguard ETF share classes?

I’ve long been a proponent of using Vanguard Admiral Share class mutual funds over their ETFs. But things sometimes change. Recently, Vanguard announced the following changes in ETF expense ratios:

I almost missed the announcement that noted, “As a result, the ETF share class of these 10 funds is now lower than their Admiral share class counterparts.” Vanguard spokesperson John Woerth told me this is the first time ETF share classes were lowered below Admiral share classes.

I quickly saw that my favorite Total International Stock Index Mutual Fund (VTIAX) was left with a 0.11% annual expense ratio, 0.02 percentage points higher than its ETF share class (VXUS). This translates to an extra $2 a year per $10,000 invested. Though not huge, it can add up over time.

“What’s largely driving these changes is the increasing adoption of ETFs by Vanguard investors as their index vehicle of choice, which has enabled us to pass along the cost savings of scale,” Woerth said. “To put some numbers around it, even though ETFs make up only about 20% of our assets, they’ve garnered more than 35% of Vanguard’s net cash flow over the past three years.”

Elisabeth Kashner, head of ETF research at FactSet, confirmed that ETFs are less expensive for Vanguard because it saves the administrative costs around record-keeping, which gets transferred from the asset manager to the brokerage firm.

In addition, Vanguard saves money on not taking client calls on Vanguard ETFs held at non-Vanguard brokerage firms, according to John Rekenthaler, vice president of research at Morningstar.

Change Is Easy

The nice thing about most Vanguard mutual funds is that they allow for tax-free conversions to the ETF share class for the vast majority of mutual funds where ETF share classes exist. If done at Vanguard, there are no fee or tax consequences, other than a possible minor gain from having to sell a fractional share since the conversion must be in whole numbers of ETF shares.

Further, the conversions are done at net asset value, Woerth says. In other words, $10,000 of VTIAX would be converted to the same $10,000 NAV of VXUS, though you may see a little more or a little less depending on whether VXUS is trading at a premium or discount.

What To Consider

While converting your mutual funds is easy, tax-free and cost-free, it may still not be the right thing to do. That’s because mutual funds still have such advantages as:

• Can buy at NAV with no bid/ask spread
• Can buy at NAV with no premium or discount
• Ability to purchase fractional shares
• Ability to set up automated purchases such as monthly amounts to buy or sell
• Dividends get reinvested faster, so there is less of a cash drag

Also, if you choose “specific lots” for tax reporting (which is more tax efficient), make sure you identify this before you do the conversion. Vanguard says lots purchased before Jan. 1, 2012 will revert to the average cost basis. If, however, you hold the mutual fund shares outside of Vanguard, the rules could be different.

Should You Convert?

I think it’s a close call. The automation may be worth a few basis points. On the other hand, you can have your cake and eat it too if you convert your current holdings to ETFs and make new automated purchases in the Admiral mutual fund share class. Of course, that creates complexity.

And conversion is a one-way street. While Vanguard allows the conversion of mutual funds to the ETF share class, it doesn’t allow the reverse.

Ultimately, however, this change may be good for all share classes. Kashner noted ETFs help increase tax efficiency for the entire portfolio, as redemptions allow for the removal of low-basis stock. 

If Vanguard is expecting redemptions—perhaps if the market turns negative for an extended period—they might be positioning themselves to take advantage of the opportunity to decrease potential tax liability.

(Disclosure: I own VTIAX and VGTSX.)

Allan Roth is 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 CBS MoneyWatch.