Now, the average performance drag is only 0.67%. The fees are much lower and many of the tax drags are lower as well. The difference in performance drag is substantial. Your actively managed portfolio would need to outperform the market by 1.28% to deliver the same post-fee and post-tax performance as the portfolio of index funds. Note: this data is collected from Morningstar in October, 2006. The average tax drag is the average tax loss over the past 5 years.
While index funds are great, there are some problems that you may encounter. We’ll describe some of these issues here:
Management fees vary by the fund provider. While many index funds are low cost, some actually have management fees that are similar to the level of an actively managed fund.
Not all indices are created equal. Some may not adequately represent the entire asset class. Other indices may have excessive turnover due to the mechanism used to determine which stocks are included in the index.
Some funds don’t track their index as close as you would want. Tracking error is the term used to describe the discrepancy in performance between the fund and the index. This error can be due to the fact that the fund only holds a sample of the stocks in the index. Tracking error can be a positive to you if your fund outperforms the index. In general, you probably want a fund with little tracking error.
We recommend using Vanguard for index funds. Vanguard has extremely low costs and is sensitive to choosing indices in asset classes that are representative of the asset class and possess low turnover. You should do your homework and read about the funds but Vanguard is a great place to start.
An alternative to buying an index fund would be to purchase exchange traded funds (ETFs). ETFs are a relatively new type of investment instrument which have become popular in the last 15 years. Unlike open-ended mutual funds, ETFs trade on stock exchanges and thus can be traded during the day. An ETF will typically try to replicate the performance of an index. ETFs have ticker symbols and you can buy and sell them through a brokerage account. Like stocks, ETFs will issue prospecti with detailed information about the security. Some examples of ETFs are the SPDR (ticker is SPY — based on the S&P 500), iShares S&P 500 index fund (IVV) and iShares MSCI EAFE index fund (EFA). There are many more which track all sorts of existing indices.
ETFs have many advantages over actively managed funds (and even index funds in some cases). First, ETFs are generally passive investment vehicles so the expense fees will be low. For example, the SPDR ETF has an expense ratio of 0.1%. In general, ETFs will not be as cheap as the least expensive index funds but you should be able to find some relatively cheap ones.
Additionally, turnover can be quite low in some of the indices that ETFs track. Thus, the trading expenses incurred by the fund manager will be lower.
A big benefit of ETFs is that they enjoy a tax advantage over index funds. ETFs are created by a manager who will sell "creation units" to institutional investors in exchange for the actual securities that compose the index. Then, the institutions will trade these creation units on the market which allows individual investors to purchase shares of the ETF. When individual investors sell their ETF shares, they are using just trading with another individual. Thus, no stock needs to be redeemed. Thus, there is no potential for an unrealized capital gain that must be realized. Secondly, when a shareholder redeems a creation unit in exchange for underlying shares, the ETF manager is able to give the lowest cost basis shares to the departing shareholder. Therefore, the cost basis of the remaining shares will be high which reduces the unrealized capital gains held by the ETF. For a more detailed discussion of this topic, please refer to ETF Tax Efficiency.
Of course, there are also some drawbacks to using ETFs. Let’s detail some of these issues:
You generally need to pay a brokerage commission anytime that you buy or sell shares in the ETF. This can be a significant expense if you buy/sell frequently or are buying a small number of shares.
The expenses of some ETFs are actually quite high. Be sure to research these fees before making a purchase. There are usually low cost ETFs available unless you are looking for something very exotic.
Some ETFs are not heavily traded so there can be a significant bid-ask spread on the market. This represents that money that you would lose if you bought and then sold the ETF shares immediately afterwards.
The tax advantage of ETFs is not enjoyed by Vanguard’s ETF which are set up in a non-traditional manner. Their ETF shares are actually just a different share class of the corresponding index fund.
You should be careful of some ETFs which are based on indices that are not well constructed. These may require excessive trading of the underlying assets.
You must remember that owners of ETFs are also taxed on dividends distributed by the stocks in the index. Under the new U.S. tax policy, there is a substantial tax break for qualified dividends (refer to Qualified Dividends for a description). But one key requirement is that the share must be held for at least 60 days during the pre-dividend period. Some ETFs will have recently traded these stocks so you may be taxed at the higher rate (which is your ordinary income rate versus the new 15% qualified dividend rate). Vanguard claims to focus more attention on this issue than some of the other ETF providers (like Barclays).
Since the ETFs trade as stocks, you might not be able to have dividends and capital gains reinvested by your brokerage. You should check with your broker to see if this is possible. If they can’t, you might want to find a low cost broker who will do this for you.
Despite these drawbacks, we think that low-cost ETFs are a sound alternative to index funds. We recommend Barclays Global Investors as a good provider of lower cost ETFs. Their products are called iShares. The SPDR ETF should also be considered as it seems to actually have the lowest expense ratio of any ETF.