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The Cost (to an Index Fund) of Turnover in an Index

A reader writes in, asking:

“When stocks enter or leave an index, an index fund is forced to sell the leaving stocks and buy the entering ones. I have heard that this results in a cost to the index fund. Is this cost big enough to matter much?”

There are two types of costs imposed on an index fund when stocks move in or out of the index that the fund tracks: transaction costs and front-running costs.

Transaction costs are the brokerage costs and bid/ask spreads incurred by buying and selling shares of a stock.

Indexes themselves, unlike index funds, have no transaction costs. As such, transaction costs would show up in the form of “tracking error” (i.e., the amount by which an index fund trails the performance of its respective index). As it turns out though, most index funds from reputable providers (e.g., Vanguard, Fidelity) don’t often trail their indexes by amounts significantly more than their expense ratios. In other words, the total transaction costs for such funds are often sufficiently small that they typically don’t even make an observable impact on fund performance.

Given the above, and given that transaction costs from stocks entering/leaving the index are only a part of an index fund’s overall transaction costs, we can confidently conclude that the transaction costs specifically resulting from changes in the index must be very small.

The second type of costs, front-running costs, are the reduction in performance that results from other parties bidding up the price of a stock by buying shares after the announcement that the stock will be added to a given index but before index funds buy it. It’s difficult to estimate such costs because they don’t show up as tracking error, because such costs affect the performance of the index itself as well as the performance of index funds.

In the last decade, two studies estimated the cost of front-running to be in the 0.2-0.3% per year range for index funds that track the S&P 500. That would certainly be a significant cost over time. However, other parties have argued that the cost has likely declined (and will continue to decline) as front-running opportunities are largely eliminated due to the idea becoming so well known.

In addition, you’re largely unaffected by such costs if you stick to “total market” funds, because your fund would already hold such stocks well before the bidding up that happens when the stock is announced for inclusion in something like the S&P 500.

So in short, yes, costs are imposed on an index fund when stocks are added to or removed from the index that it tracks. However, such costs (both transaction costs and front-running costs) tend to be very small, especially for the most diversified index funds.

What’s the Maximum Expense Ratio Somebody Should Pay for a Mutual Fund?

A reader writes in, asking:

“As I try to select among the funds in my 401k plan, is there a limit to the high end of expense ratio that you suggest not going beyond?”

The maximum expense ratio that I would pay for a fund depends on the context. Specifically, it depends on the availability of a less expensive suitable substitute.

For example, consider an investor with a $100,000 portfolio, all of which is in her 401(k). She has decided that her ideal asset allocation would be:

  • 60% in US stocks,
  • 20% in international stocks, and
  • 20% in bonds.

And, in her 401(k), the lowest-cost investment options in each of those categories are:

  • A “total stock market” index fund with an expense ratio of 0.1%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

Our investor has a dilemma. She wants a 20% international stock allocation in her portfolio. But she would have to pay an extra 0.6% per year for that part of the portfolio in order to have such an allocation (rather than just allocating the entire stock part of the portfolio to the US stock index fund).

Frankly, if I were in that position, I wouldn’t pay the additional cost. I appreciate international diversification, but an avoidable cost of 0.6% per year is a high hurdle for the diversification to overcome in terms of added value.

But what if our investor’s lowest-cost investment options were as follows?

  • An actively managed US stock fund, with an expense ratio of 0.65%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

In this case, our hypothetical investor would now only be paying an additional 0.05% per year for her international allocation. The international fund’s cost hasn’t changed at all, but it has become quite a bit more attractive because the alternative (i.e., keeping the entire stock allocation in the US stock fund) has become more expensive.

Point being: The maximum expense ratio that it makes sense to pay depends on the cost and suitability of the nearest substitute. In our first scenario the 0.7% expense ratio was too high because there was a low-cost substitute (albeit an imperfect substitute). In the second scenario, the 0.7% expense ratio was not prohibitive, because there was no low-cost substitute.

What if There Are Multiple Accounts?

Let’s look at one more hypothetical scenario. Our investor still desires an allocation of 60% US stocks, 20% international stocks, and 20% bonds. And the options in her 401(k) are the same as in our first scenario above:

  • A “total stock market” index fund with an expense ratio of 0.1%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

In this case, however, her portfolio consists of $50,000 in her 401(k) and $50,000 in a Vanguard IRA. In this case, she has no reason whatsoever to pay the high cost of the international fund in her 401(k), because she could achieve her desired overall allocation by buying an international index fund/ETF in her IRA.

Again, the overall conclusion is that the maximum “acceptable” expense ratio for a fund varies based on the availability of less expensive suitable substitutes.

Why Don’t Vanguard’s Target Retirement and LifeStrategy Funds Own Admiral Shares?

One question I receive periodically is why the Target Retirement and LifeStrategy funds at Vanguard hold “Investor” shares of the underlying funds, rather than the less expensive “Admiral” shares. Emily Farrell, Head of U.S. Business PR at Vanguard, was kind enough to provide the answer.

—–

Piper: Why don’t the LifeStrategy and Target Retirement funds use Admiral shares as the underlying holdings?

Or, if there’s a concern about that being a way to “cheat” to get access to Admiral shares without meeting the requirements, why not have an Admiral share class for the LifeStrategy and Target Retirement Funds, with a higher minimum investment (i.e., a high enough figure such that a person investing that amount via an identical DIY allocation would qualify for Admiral shares of all or most of the underlying funds)?

Farrell: Vanguard is unable to offer multiple share classes on funds of funds due to the structure in which we operate, and the agreement we have with the SEC regarding multiple share classes. Our funds of funds have no direct costs — the costs are derived only from the ERs of the underlying funds. According to that agreement, we must be able to offer a differentiated cost advantage between share classes. (Therefore, because there is no direct cost associated with a fund of fund — it’s not possible for us to offer such an advantage).

As you may recall, we launched a suite of Institutional TRFs in 2015. Note, however, those are not share classes — they are an entirely new set of mutual funds.

Piper: Given that Vanguard can only have one share class of a fund-of-funds, how does Vanguard decide which share classes to hold within such funds? The “normal” (non-institutional) versions of the funds-of-funds each hold Investor shares of the underlying funds. Would Vanguard ever consider holding Admiral share classes in these funds?

And, for example, the Vanguard Institutional Target Retirement 2050 Fund (VTRLX) holds Institutional shares of one underlying fund, Admiral shares of another fund, and Investor shares of two funds. What’s the line of thinking there?

Farrell: It is largely based on the cost to serve the underlying shareholder of the TRF or LifeStrategy Fund. These funds tend to attract small balance accounts and IRAs, and the cost to serve is disproportionately higher than funds with large and diverse shareholders. In terms of looking into adding holding Admiral in the Investor suite of TRFs, in short, the answer is yes — we consistently review our products, product structures, and product line-ups. However, given the size of the average TRF account and our cost allocation methodologies, we would not expect a change from Investor Shares. Specific to the underlying holdings of the Institutional suite of TRFs, again, it is cost to service the funds and our cost allocation methodologies that dictate the share class utilized.

—–

So, to paraphrase, Vanguard’s position here is, “in a Target Retirement or LifeStrategy fund, we hold whichever share class (or share classes) result in an expense ratio that most closely reflects the cost to service the fund’s shareholders.” In hindsight, that feels sort of obvious, given Vanguard’s general “at cost” pricing philosophy.

8 Simple Portfolios with Fidelity Funds (and iShares ETFs)

A reader writes in, asking:

“Your page of 8 simple portfolios is great guidance for people who want a simple plan they can institute. I wondered whether that page could offer a list of Fidelity options for some of those portfolios…if they are up-to-snuff enough and low-cost enough.”

The idea of the original “8 simple portfolios” article was to provide a menu of several possible portfolios, sorted by complexity (i.e., a one-fund portfolio, two-fund portfolio, and so on). At the time, I listed Vanguard funds simply because they are my go-to company for index funds.

But, to be clear, Fidelity does have a perfectly good lineup of low-cost index funds. In addition, they offer commission-free trades on a number of iShares ETFs, which can also be used to build a low-cost, diversified, simple portfolio.

Before we get into the portfolios, let me answer a few questions first:

  • As with the previous article, in order to make comparisons easy, each of the portfolios is built using the same overall stock/bond allocation (70/30). There’s no particular reason that a 70/30 split was chosen over any other allocation. Investors with differing levels of risk tolerance would want to adjust as necessary to meet their needs.
  • Each of the portfolios uses a roughly 50/50 domestic/international allocation for the stocks, because that is what I used to use when I had a DIY portfolio. Such an allocation is not going to be a good fit for everybody. Again, adjust as necessary to match your risk tolerance.
  • I’m using the ticker symbols for the “Premium” share class for the Fidelity index funds, but the “Investor” share class versions are perfectly good options if you don’t meet the minimum investment requirement for the Premium versions.
  • With regard to tilting the portfolio toward small-cap stocks and/or value stocks: I have never done this with my own portfolio, but such tilts are one of the more compelling reasons to include several (i.e., more than three or four) funds, so I am assuming that that is the goal of the more complex allocations.

One-Fund Portfolio

I would caution against accidentally buying a “Fidelity Freedom Fund” rather than a “Fidelity Freedom Index Fund.” The non-indexed versions are quite a bit more expensive and include a whole list of bizarre allocations.

Two-Fund Portfolio

  • 70% iShares MSCI All Country World Index ETF (ACWI)
  • 30% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF  (AGG)

Three-Fund Portfolio

  • 35% Fidelity Total Market Index Fund (FSTVX) or iShares Core S&P Total U.S. Stock Market ETF (ITOT)
  • 35% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 30% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)

Four-Fund Portfolio

  • 30% Fidelity Total Market Index Fund (FSTVX) or iShares Core S&P Total U.S. Stock Market ETF (ITOT)
  • 10% Fidelity Real Estate Index Fund (FSRVX)
  • 30% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 30% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)

Five-Fund Portfolio

  • 30% Fidelity Total Market Index Fund (FSTVX) or iShares Core S&P Total U.S. Stock Market ETF (ITOT)
  • 10% Fidelity Real Estate Index Fund (FSRVX)
  • 30% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 15% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)
  • 15% Fidelity Inflation-Protected Bond Index Fund (FSIYX) or iShares TIP Bond ETF (TIP)

Six-Fund Portfolio

  • 20% Fidelity 500 Index Fund (FUSVX) or iShares Core S&P 500 (IVV)
  • 10% iShares S&P Small-Cap 600 Value Index (IJS)
  • 10% Fidelity Real Estate Index Fund (FSRVX)
  • 30% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 15% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)
  • 15% Fidelity Inflation-Protected Bond Index Fund (FSIYX) or iShares TIP Bond ETF (TIP)

Seven-Fund Portfolio

  • 20% Fidelity 500 Index Fund (FUSVX) or iShares Core S&P 500 (IVV)
  • 10% iShares S&P Small-Cap 600 Value Index (IJS)
  • 10% Fidelity Real Estate Index Fund (FSRVX)
  • 20% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 10% iShares MSCI EAFE Small-Cap Index (SCZ)
  • 15% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)
  • 15% Fidelity Inflation-Protected Bond Index Fund (FSIYX) or iShares TIP Bond ETF (TIP)

Eight-Fund Portfolio

  • 20% Fidelity 500 Index Fund (FUSVX) or iShares Core S&P 500 (IVV)
  • 10% iShares S&P Small-Cap 600 Value Index (IJS)
  • 10% Fidelity Real Estate Index Fund (FSRVX)
  • 10% Fidelity Total International Index Fund (FTIPX) or iShares Core MSCI Total International Stock (IXUS)
  • 10% iShares MSCI EAFE Small-Cap Index (SCZ)
  • 10% iShares International Select Dividend (IDV)
  • 15% Fidelity U.S. Bond Index Fund (FSITX) or iShares Core U.S. Aggregate Bond ETF (AGG)
  • 15% Fidelity Inflation-Protected Bond Index Fund (FSIYX) or iShares TIP Bond ETF (TIP)

Portfolio Turnover: How High is Too High?

A reader writes in, asking:

“When looking at a mutual fund at what point would you say it has a high turnover ratio? For example, I have a Mid-Cap value fund that has a 39% turnover ratio. Do you think this is too high? What are your thoughts on this?”

A turnover rate doesn’t mean anything without context.

For example, Vanguard’s Short-Term Treasury Index Fund — which is entirely passive — has a turnover rate of 211% according to Morningstar. That sounds super high, but for a short-term bond fund, it’s actually quite reasonable. The bonds in the portfolio mature frequently given their short-term nature, so the fund has no choice but to frequently buy new bonds.

Of course, stocks don’t “mature” like bonds do. But, at least for index funds, there is still going to be some degree of forced turnover for a fund when a stock it is holding moves out of the targeted category. And the more specific the targeted category, the greater that level of turnover.

For example, a mid-cap value index fund would have turnover whenever a holding becomes too large or too small to be classified as mid-cap. And it would also have (less common) turnover when a stock moves from being considered “value” to being considered “growth.”

And, therefore, a mid-cap blend fund (with no value/growth tilt) would generally have less turnover than a mid-cap value fund — because the mid-cap blend fund only has one source of forced turnover (i.e., one way in which stocks can move out of the targeted category) whereas the mid-cap value fund has two. Similarly, a value fund (with no specification as to market-cap) will also generally have less turnover than a mid-cap value fund. And a “total market” type of fund would have even less natural turnover, because companies only go out of the “total market” when they cease to exist as publicly traded companies.

And these expectations are in fact borne out if we look at the turnover rates for Vanguard index funds in these categories.

According to the Investment Company Institute, the asset-weighted portfolio turnover rate experienced by stock-fund investors for 2015 was 44%. (The fact that this is “asset weighted” means that larger funds count more heavily in the calculation than smaller funds.) So the turnover rate of 39% mentioned by the reader for his mid-cap value fund is below average for a stock fund, despite the fact that this fund is in a category that would typically lead to higher turnover than a more broadly diversified stock fund.

That said, the turnover rate is still roughly twice that of the Vanguard index fund in the same category.

In his book Bogle on Mutual Funds, John Bogle estimates that a fund’s costs from turnover will be in the rough ballpark of 1.2% x the reported annual turnover rate. So, for example, a fund with a 100% annual turnover rate will experience a “hidden” cost of approximately 1.2% per year. But that is of course just an estimate, and the actual costs will vary from one fund category to another.

Do Vanguard Funds Have Hidden Costs?

A reader writes in, asking:

“I recently met with a financial advisor to look over my portfolio. Currently, I use the ‘three fund portfolio’ that is recommended on the Bogleheads website: Vanguard’s total stock, total international, and total bond funds. The advisor said that while Vanguard index funds are OK, he thinks they’re over-rated because they have hidden costs and they aren’t actually as cheap as Vanguard states in their marketing. Is that true?”

Every typical mutual fund (index or otherwise) has “hidden costs” as a result of portfolio turnover. That is, when a mutual fund buys or sells investments, it incurs costs in the form of commissions and bid/ask spreads. And these costs are hidden in the sense that they are not included in the fund’s reported expense ratio, despite the fact that they have a downward drag on performance.

What’s ironic about this advisor’s assertion is that:

  1. Index funds (especially “total market” funds) tend to have very low turnover costs, and
  2. It’s much easier to estimate an index fund’s turnover costs than an actively managed fund’s turnover costs.

In other words, relative to the hidden costs of actively managed funds, the hidden costs of index funds are typically a) less hidden and b) lower.

Why Index Funds Usually Have Lower Turnover Costs

The reason why index funds typically incur lower portfolio turnover costs than actively managed funds is simple: index funds generally have a lower rate of portfolio turnover.

For example, Morningstar currently reports that Vanguard Total Stock Market Index Fund has annual portfolio turnover of just 3%. Look up any handful of actively managed stock index funds, and the most likely outcome is that all of them will have portfolio turnover well in excess of 3% per year.

How to Estimate the Turnover Costs of an Index Fund

With index funds, it’s pretty easy to get an idea of the magnitude of such hidden costs. To do so, check how the fund’s long-term performance compares to the performance of the index that it tracks. For example if:

  • A given index has an annual return of 7.0% over the last 10 years,
  • A particular index fund tracking that index has a return of 6.85% over those 10 years, and
  • The fund has an expense ratio of 0.1%…

…then we can estimate that the fund’s “hidden costs” are in the ballpark of 0.05% per year. (That is, if the fund’s performance trails the performance of its benchmark by 0.15% per year, and the fund has a 0.1% expense ratio, the remaining 0.05% performance gap serves as a decent estimate of such “hidden” portfolio turnover costs.)

With regard to the advisor’s assertion about Vanguard specifically, it’s worth pointing out that, in many cases, Vanguard’s index funds actually trail their benchmarks by an amount that’s less than their expense ratios. In other words, the hidden costs are sufficiently small that they are outweighed by the “hidden revenue” the funds earn from securities lending.

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