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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.

What to Do When Index Funds Are More Expensive

A reader writes in, asking:

“The problem my husband and I have encountered is that the index funds in his work retirement plan have high expenses, around 1%. The gap between index and non-index is small or non-existent for some asset categories. When confronted with such a situation, should you still go for the index fund, or is the non-index fund worth considering? What if the non-index fund is actually a little less expensive than the index fund, as is the case for one of our asset categories?”

My primary reason for (usually) preferring index funds is that:

  1. There’s been quite a bit of research over the years showing that funds with lower expense ratios tend to outperform funds with higher expense ratios, and
  2. Index funds tend to be less expensive than actively managed funds.

In other words, it’s (primarily) about costs. Given the choice between a) an active fund with a given expense ratio or b) an index fund with a higher expense ratio, I would usually be inclined to go with the lower-cost fund, even though it isn’t an index fund.

For instance, several of Vanguard’s actively managed bond funds (such as their Inflation-Protected Securities Fund, Treasuries funds, or tax-exempt bond funds) have lower expenses than many index funds in the same categories, and I would have absolutely no qualms about using the Vanguard actively managed fund rather than a more expensive index fund.

That said, there is one big concern about using an actively managed fund, even when it’s the lowest-cost option: manager risk. That is, because the manager has more leeway in how to invest an actively managed fund’s assets, there is a greater chance that the manager will use that leeway to do something stupid.

Fortunately, there are a few steps you can take to at least somewhat minimize the likelihood that you’ll be caught off guard by manager risk.

  1. To the extent possible, only use fund companies that you trust.
  2. Check the fund’s prospectus to see how much leeway the manager has in changing the fund’s asset allocation.
  3. Check to see whether there have been dramatic allocation changes in the past. One way to do this is to chart the fund’s performance against that of an index fund in the same asset class. If they have very closely tracked each other, it’s likely that the fund manager is not wildly changing the allocation over time.

Vanguard Increases International Allocation to Target Retirement and LifeStrategy Funds

A few readers have asked what I think about the recent announcement that Vanguard will be increasing the international allocation in the Target Retirement and LifeStrategy funds. (In case you missed the announcement: The international equity allocation will increase from 30% to 40%, and the international bond allocation will increase from 20% of nominal fixed-income to 30% of nominal fixed income.)

Is Increasing International Allocation a Good Idea?

The most important part of the answer is that I don’t have any strong opinion about the merits of the change itself. We’re talking about 10% of the portfolio (or less, in some cases). And the change isn’t even from stocks to bonds or vice versa. It’s just from domestic to international. In other words, I don’t expect it to have a particularly large effect.

I’m not thrilled about the bond change, because I’m not especially enamored with the Total International Bond Index Fund. It has a higher expense ratio than the Total Bond Market II Index Fund (0.23% rather than 0.12%). And, despite having more interest rate risk (due to an average duration of 7.3 years rather than 5.6) and more credit risk, it has a significantly lower yield (as of this writing, 0.81% as opposed to 1.94%).

As far as the stock change, it doesn’t bother me. Back when I used a DIY allocation, I used a 55/45 domestic/international split. Also, while I am not the type to make tactical asset allocation changes, with Vanguard Total International Stock Index Fund having underperformed Vanguard Total Stock Market Index Fund so heavily over the last 5 years (6.53% annualized return as opposed to 16.26%), if there was ever a time to move more heavily to international stocks, now would seem to be it.

In other words, I’m slightly happy about one aspect of the change and slightly unhappy about the other aspect of the change. But, again, I wouldn’t expect the overall effect to be a big deal. It’s a modest change to a small part of the portfolio.

But I Wish They’d Stop Tinkering

The thing that I most dislike about the change is simply the fact that it’s a change. A big part of the reason that I hold a LifeStrategy fund is to counteract my temptation to tinker — to make it easy to buy and hold a given asset allocation. But, unfortunately, the portfolio is being tinkered with, even if I’m not the one doing it.

That said, to Vanguard’s credit, they’re open about that fact. For example, back in 2012, in an interview for Oblivious Investor readers, Vanguard’s John Ameriks made the following statement:

In terms of changes to target date, it’s important to say that we do expect these portfolios to evolve over time. We are going to continue to do research. We are looking at these things on an ongoing basis and doing formal updates of our analysis around the glide path. We look at it a lot. But that doesn’t mean we’re going to change it.

[…]

At this point, there are no specific plans to make changes to the target date funds. But I would make sure that everyone understands that it is not something that we set and forget. We’re constantly looking for ways to either improve diversification or reduce costs or provide a better fit for the shareholders. So people should expect some evolution over time.

What will not change is the philosophy: that it should be easy for every investor to understand what’s going on in those funds.

In other words, I do not love the fact that Vanguard changes the Target Retirement and LifeStrategy portfolios from time to time, but I can’t claim to be surprised that it happens.

Should I Invest in Schwab’s Fundamental Index Funds?

A reader writes in, asking:

“I currently use three Schwab ETFs for my portfolio: Schwab U.S. Broad Market, Schwab International Equity, and Schwab Short-Term U.S. Treasury. But I’ve been reading about their Fundamental Index Funds and ETFs as well. The idea of allocating to companies according to sales and cash flow makes a lot of sense to me. Do you think it would be prudent to add some of these funds to my existing holdings?”

As a bit of background information: Traditional index funds (and ETFs) are market-cap weighted. This means that each stock (or bond) held in the fund is held in proportion to its market capitalization (i.e., the total market value of the company). For example, if Verizon makes up 1% of the U.S. stock market, a market-cap weighted U.S. “total market” index fund would have 1% of its portfolio invested in Verizon.

In contrast, “fundamental” index funds (and now, in some cases, “smart beta” funds) weight companies according to their “fundamentals” (i.e., metrics such as sales, cash flow, or net income).

While I don’t think its typically useful to compare the performance of two funds in order to see which fund is better (remember, picking based on past performance is often worse than picking randomly), I do think it can be helpful to plot the performance of two funds on the same chart to see how similar they are.

For example, with these various new types of not-so-passive index funds, it’s often enlightening to:

  • Look at where the fund falls in the tic-tac-toe-looking Morningstar style box (i.e., growth vs. value and small-cap vs. large-cap),
  • Find a plain-old Vanguard fund with a comparable position in the style box, and
  • Plot the two funds together on the same growth chart.

With regard to the reader’s question, let’s run through the above exercise with three Schwab Fundamental Index Funds.

Our first chart shows the Schwab Fundamental US Large Company Index Fund (SFLNX, in blue) and the Vanguard Large-Cap Index Fund (VLCAX, in orange), since the inception of the Schwab fund:

Large-cap

The following chart shows the Schwab Fundamental US Small Company Index Fund (SFSNX, in blue) and the Vanguard Small-Cap Index Fund (VSMAX, in orange), since the inception of the Schwab fund:

Small-Cap

And the final chart shows the Schwab Fundamental International Large Company Index Fund (SFNNX, in blue) and the Vanguard International Value Fund (VTRIX, in orange), since the inception of the Schwab fund:

International

You can see periods in each of these charts in which one fund outperforms the other, but the overwhelming takeaway that I see is simply how very similar the funds are.

And that’s typically how it goes when I look at a fund in one of these newer categories. They’re usually perfectly fine funds. (After all, going toe-to-toe with a low-cost index fund from the most respected provider of index funds is nothing to laugh at!) But there’s usually little substance behind the marketing message that these are a distinct improvement over traditional index funds. For the most part, they’re simply a new way of arriving at the same old portfolio (or very close to it).

Index Fund Portfolios vs. Active Fund Portfolios

Perhaps the most-referenced source in the “active vs. passive” debate is the ongoing series of Standard and Poor’s SPIVA scorecards. The SPIVA studies (updated twice each year) consistently show that most actively managed mutual funds fail to outperform their benchmark index. In other words, if you randomly picked a fund, you would have a less than 50% chance of outperforming an index that tracks the performance of the asset class in question.

While that’s interesting information (and it’s nice to have a consistently up-to-date source for figures), it’s worth noting that the question the studies answer has some limitations with regard to its real-life applicability.

First, the studies compare the performance of real-life actively managed funds to the performance of an index, yet an index is not something we can invest in. We can only invest in index funds, which (unlike the indexes themselves) have expenses

Second, most investors aren’t picking funds randomly. They’re doing better than that. For example, John Reckenthaler (Morningstar’s Vice President of Research) found last year that in most fund categories, the asset-weighted performance is better than the equal-weighted performance (meaning that investors are putting the majority of their assets into funds that perform better than the middle of the pack).

This shouldn’t be terribly surprising. Given the evidence that the poorest-performing group of funds tends to continue to perform poorly, all investors have to do is avoid choosing funds with terrible past performance in order to have a decent likelihood of a better-than-random selection.

Third, looking at the “active vs. passive” question on a fund-by-fund basis is probably less applicable than looking at things on a whole-portfolio basis.

A New Look at the Active vs. Passive Question

In a recent study, Rick Ferri (of Portfolio Solutions) and Alex Benke (of Betterment) looked at the likelihood of a portfolio of actively managed funds outperforming a portfolio of index funds. In other words, they took two big steps closer to reality by comparing actively managed mutual funds to actual, investable index funds and by looking at how an active fund portfolio is likely to compare to an index fund portfolio.

The specific figures vary depending on the period and asset allocation tested, but the general conclusion is that a portfolio of actively managed funds has a much less than 50% chance of outperforming an index fund portfolio. And that chance gets smaller as you look at longer periods of time. In addition, in scenarios in which the portfolio of active funds outperforms the portfolio of index funds, it tends to outperform by a smaller amount than the amount by which it underperforms in scenarios in which it loses.

Perhaps the most interesting part of the study was that Ferri and Benke also checked to see how the results change when you exclude actively managed funds with above-average costs from the active fund portfolios. (I think this is a useful test given that investors do tend to put the majority of their money into funds on the low-cost half of the spectrum.) The answer: Excluding high-cost funds meaningfully improves the results for the active portfolios, but the degree of improvement is still well below what would be necessary for an active fund portfolio to be a good bet.

I’d be interested to see what happens if the very same idea is carried further. For example, what if the active portfolios were constructed such that they only included funds in the bottom 25% in terms of expenses? What about the bottom 10%? Is there a point at which the cost difference is small enough for the actively manage funds to, on average, outperform (or roughly tie) the index fund portfolios?

The Best (Low-Cost) Index Funds

When choosing between companies for constructing an index fund portfolio, my primary considerations would be:

  • Cost of funds,
  • Minimum investment per fund, and
  • Selection of funds (Does this company have enough funds for me to build a diversified portfolio?).

What follows is a comparison of index funds from Fidelity, Schwab, and Vanguard. (I also took a look at T. Rowe Price’s index funds. Conclusion: Their selection is limited, and their funds cost more than any of the other three companies. Not particularly enticing, in my opinion.)

As a point of comparison, I’ve specifically mentioned funds from each company that could be used to construct Allan Roth’s “Second Grader Portfolio,” which consists of three basic asset classes: U.S. stocks, international stocks, and bonds. This is not to suggest that these are necessarily the only funds a person might want to use.

Fidelity Index Funds

  • Spartan Total Market Index Fund (expense ratio: 0.06%)
  • Spartan International Index Fund (expense ratio: 0.12%)
  • Spartan U.S. Bond Index Fund (expense ratio 0.10%)

Minimum Investment: $10,000 minimum initial investment per fund for the “Advantage” share class, for which I’ve listed the expense ratios. There’s also an “Investor” share class (which has slightly higher — though still low — costs), for which the minimum investment is $2,500 per fund.

Selection: Fairly limited. For example, investors looking to tilt their portfolios toward growth stocks or value stocks won’t find the tools to do so, as there are no value-specific or growth-specific Spartan index funds.

Related note: Fidelity has a lot of “enhanced index funds.” I wouldn’t bother with them. Their costs are low for active funds, but still usually significantly higher than decent index funds.

More information about Fidelity’s index funds can be found here.

Schwab Index Funds

Schwab’s selection of  actual index funds leaves much to be desired. (For example, they don’t even have a single bond index fund.) Schwab does, however, offer commission-free trades on their own ETFs, many of which are low-cost, index-tracking ETFs.

  • Schwab U.S. Broad Market ETF (expense ratio: 0.04%)
  • Schwab International Equity ETF (expense ratio: 0.09%)
  • Schwab U.S. Aggregate Bond ETF (expense ratio: 0.05%)

Minimum Investment: As ETFs, the minimum investment is simply the cost to purchase one share of the fund. As a result, most Schwab ETFs can be accessed with amounts as small as $50.

Selection: Somewhat limited. For example, Schwab has growth/value domestic large-cap ETFs, but no such offerings in the small-cap or international categories.

More information about Schwab’s ETFs can be found here.

Vanguard Index Funds

  • Vanguard Total Stock Market Index (expense ratio: 0.05%)
  • Vanguard Total International Stock Index (expense ratio: 0.16%)
  • Vanguard Total Bond Market Index (expense ratio: 0.10%)

Minimum Investment: $10,000 minimum initial investment per fund for the “Admiral” share class, for which I have listed the expense ratios. There’s also an “Investor” share class, with slightly higher (though still low) expenses, for which the minimum investment per fund is $3,000. (As yet another alternative, if you have an account at Vanguard, you can get commission-free trades on the ETF versions of Vanguard’s index funds, which carry the same expense ratios as their Admiral Shares funds.)

Selection: Very broad. Vanguard has more than 30 different index funds, covering pretty much every asset class you can think of.

More information about Vanguard’s index funds can be found here.

Conclusion

In short, which company to use depends upon your situation. If you intend to build a somewhat more complicated portfolio — such as one that overweights value or small-cap stocks — go with Vanguard. But if that’s not a concern for you, any of the three companies could be a perfectly good choice (though Fidelity will be less desirable if you cannot meet the minimum investments on their index funds).

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