ETFs vs index funds for taxable and tax deffered accounts?

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Topic Author
ploldo
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Joined: Sun Oct 30, 2011 1:23 pm

ETFs vs index funds for taxable and tax deffered accounts?

Post by ploldo »

I have 200k invested that I'm looking to move to the follow sectors:
55% world small cap ex US, 25% emerging markets, 15% value ex US, 5% US micro cap.

Currently 50% is in an SEP IRA and I expect my future contributions to be mostly weighed to this tax deferred account.

US micro cap - DFSCX
Intentional value - VTRIX
FTSE all world ex US small cap index - VFSVX (considering DFISX instead)
Emerging markets - Whatever the vanguard index one is called.

My question is which of these should I put into my IRA?
I am also wondering when ETFs are better than index funds and if it depends on whether or not the accounts are tax deferred or not. I have heard that apparently Vanguard ETFs are not as tax efficient as the average ETF.

A related stupid question based upon my understanding of capital gains tax:
If in the future I have a large amount in my taxable account, say a cool million, what if I can't afford the yearly taxes?

Thanks for your help.
Default User BR
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Re: ETFs vs index funds for taxable and tax deffered account

Post by Default User BR »

ploldo wrote:I have 200k invested that I'm looking to move to the follow sectors:
55% world small cap ex US, 25% emerging markets, 15% value ex US, 5% US micro cap.
That is a very extreme portfolio. What brought you to this decision? Do you have any fixed income to balance it?
ploldo wrote:My question is which of these should I put into my IRA?
The value and the US stocks are the most likely. However, you should probably NOT be 100% stocks.
ploldo wrote:I am also wondering when ETFs are better than index funds and if it depends on whether or not the accounts are tax deferred or not. I have heard that apparently Vanguard ETFs are not as tax efficient as the average ETF.
ETFs can be more tax-efficient. Vanguard ETFs are share classes of the mutual fund. What results is that the fund is more efficient because of that.
ploldo wrote:A related stupid question based upon my understanding of capital gains tax:
If in the future I have a large amount in my taxable account, say a cool million, what if I can't afford the yearly taxes?
There are two kinds of capital gains. Those that are generated by the fund due to trading and then distributed to the holders, and gains due to price appreciation of the shares. Only the first is taxed yearly. Most index funds don't produce much in the way of CGs. However, you must pay your taxes. There's nothing special about the situation. If you owe, you have to come up with the cash.



Brian
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ploldo
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Re: ETFs vs index funds for taxable and tax deffered account

Post by ploldo »

Thanks for your reply.

I should have mentioned that I am 26 and not concerned about any additional risk assuming it brings higher returns. Of course I am in this for the long run of 35+ years minimum. What brought me to this decision was a finance course I took. I'm looking to switch from a total stock market index, so something with more risk/return since I'm in this for the long haul.


ETFs: yes that makes sense. I also found a comparison on Vanguard between the two and ETFs seems quite a bit cheaper due to lower fees.

Capital gains: got it, thanks. So my initial thinking was that funds in my IRA should be that with the highest expected return. But based upon these CG taxes due to trading, it sounds like funds in my IRA should be a weighted combination of those I expect to have the most trades and highest returns. Is that correct?
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retiredjg
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Re: ETFs vs index funds for taxable and tax deffered account

Post by retiredjg »

Welcome to the forum!
ploldo wrote:I should have mentioned that I am 26 and not concerned about any additional risk assuming it brings higher returns.
You can't assume that. Higher risk usually does bring higher returns, but it may not or it may not in your time frame.
ETFs: yes that makes sense. I also found a comparison on Vanguard between the two and ETFs seems quite a bit cheaper due to lower fees.
Look again. Once you reach $10k in mutual funds, the costs are often the same (although I have not looked up your specific desired funds). Even if they are not the same, "quite a bit" cheaper is may be an exaggeration.

Your plan is extreme and not well thought out in my opinion. There is a middle ground between what you are considering and your current portfolio. You should consider something in the middle ground if you cannot stay with your total market portfolio.

What to put in the IRA? It depends on what other types of accounts you have. Tax-efficiency matters. For example, the value stocks and the microcaps probably should not be in a taxable account.
Default User BR
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Re: ETFs vs index funds for taxable and tax deffered account

Post by Default User BR »

ploldo wrote:I should have mentioned that I am 26 and not concerned about any additional risk assuming it brings higher returns. Of course I am in this for the long run of 35+ years minimum. What brought me to this decision was a finance course I took. I'm looking to switch from a total stock market index, so something with more risk/return since I'm in this for the long haul.
This sounds like "a little knowledge is a dangerous thing". I would recommend you study Bernstein's "The Intelligent Asset Allocator" and other similar books. Have you actually calculated extra expected returns versus risk for this portfolio versus a more mainstream one?
ploldo wrote:ETFs: yes that makes sense. I also found a comparison on Vanguard between the two and ETFs seems quite a bit cheaper due to lower fees.
True for investor funds, much less so or not at all for Admiral.



Brian
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retiredjg
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Re: ETFs vs index funds for taxable and tax deffered account

Post by retiredjg »

Default User BR wrote:
ploldo wrote:What brought me to this decision was a finance course I took.
This sounds like "a little knowledge is a dangerous thing".
Very scary.

Agree with Brian - you didn't get the full picture.
Topic Author
ploldo
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Re: ETFs vs index funds for taxable and tax deffered account

Post by ploldo »

The ETF vs index fund calculator is here:
https://personal.vanguard.com/us/faces/ ... ontent.jsp

I must have only looked at Emerging Markets previously which have considerably higher costs in an index, probably due to purchase fees in this sector. Index fund appear to be slightly cheaper for everything besides EM and ex US small cap. This is assuming admiral shares.


A lot of good criticism in here.

“Have you actually calculated extra expected returns versus risk for this portfolio versus a more mainstream one?”

I have only used a compound interest calculator. I would like to use one given different standard deviations if that exists.



I’ll probably tone my portfolio down a bit. I realize that 35 years (more like 40) is not the long run, but how far away is it? At some longer time frame, not investing fully in higher risk stocks is foolish.

In 40 years, I don’t need to have my returns approach their expected returns. I just want them to beat the overall market returns. Honestly I think there is a huge difference between these two things expectations. While I should probably be more conservative, I don’t want to risk being too conservative. 40 years is a long time to under-perform the MARKET. I would guess even with a very high volatility this is rare even if the risk premium return is only a few percentage points.

My main worry is that small cap, value, or emerging markets will not carry this premium in the future. I am far less worried about the results being there (better than the market) than this. Based upon the common tilts in this forum towards these niches, most assume this premium will continue. If in 10 years things change I can always change my mind.

So the way I see it, there is a very very small chance I under-perform the market, a decent chance I have similar returns vs the market, and a pretty good chance I crush the market.
supertreat
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Re: ETFs vs index funds for taxable and tax deffered account

Post by supertreat »

IMO long term US treasury bonds would be a good addition to this portfolio for diversification benefit. Maybe 10% of portfolio?
Assets - Liabilities = Equity + (Income - Expenses)
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retiredjg
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Re: ETFs vs index funds for taxable and tax deffered account

Post by retiredjg »

Nobody is suggesting you should not invest in the higher risk stocks. For one thing, all of that stuff is already included in a total market portfolio (well, maybe not all of the microcaps - I'm not sure). Secondly, you can always overweight toward certain sectors that you consider a good bet. But there is no reason to completely eliminate almost all (95%?) of the US stock market.

Your idea is actually more than extreme. Forgive me, but I think it is nuts!

1) You plan to use 95% international, 5% domestic.

2) You plan to put 55% of your portfolio in what is about 5% of the global market (rough numbers).

3) You plan to put an additional 25% of your portfolio in what is about 13% of the global market (again, rough numbers).

4) You apparently don't plan to have any fixed income/bonds.

This is not a good plan. I hope you'll give it more consideration.

There is one portfolio idea floating around here that I think you might like. The equity portion (yes, there is a bond portion) is 25% Large Cap blend, 25% small cap value, 25% International Value, and 25% International Small Cap blend. It would still be tilted heavily to small cap (half) and value (half), but I think it is much more reasonable than what you have in mind.
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grabiner
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Re: ETFs vs index funds for taxable and tax deffered account

Post by grabiner »

ploldo wrote:I have 200k invested that I'm looking to move to the follow sectors:
55% world small cap ex US, 25% emerging markets, 15% value ex US, 5% US micro cap.

Currently 50% is in an SEP IRA and I expect my future contributions to be mostly weighed to this tax deferred account.

US micro cap - DFSCX
Intentional value - VTRIX
FTSE all world ex US small cap index - VFSVX (considering DFISX instead)
Emerging markets - Whatever the vanguard index one is called.

My question is which of these should I put into my IRA?
I am also wondering when ETFs are better than index funds and if it depends on whether or not the accounts are tax deferred or not. I have heard that apparently Vanguard ETFs are not as tax efficient as the average ETF.
Vanguard ETFs are no more tax-efficient than the corresponding index funds, but they tend to be just as tax efficient as other ETFs. The emerging markets ETF or fund should be very tax efficient, and as of the last report, the FTSE small-cap ETF and fund no longer have a capital gain to distribute this year and should also be tax-efficient.

The DFA micro-cap fund is likely to be tax-inefficient because it does not have an ETF class, and Vanguard International Value, as an active fund, is also tax-inefficient. (If you have access to DFA, you probably want DFA's international value fund rather than Vanguard's; Vanguard's doesn't have much of a value bias.)

And if you decide to add more mainstream investments, the stocks are among the best choices for a taxable account: Total Stock Market Index for US large-cap (and some small), Total International or Tax-Managed International for foreign large-cap (and Total International includes small-cap and emerging markets as well, at the market weight).
A related stupid question based upon my understanding of capital gains tax:
If in the future I have a large amount in my taxable account, say a cool million, what if I can't afford the yearly taxes?
It's rare that this will happen, because you can only have a capital gain on the difference between the price at which you bought and sold something. If you have a $1M capital gain, you must have at least $1M at the time you realize the gain, and since you know that you will owe $150K in taxes, you should save that money.

Yes, it is possible to paint yourself into a corner. If you have a $1M capital gain in 2011, reinvest the money in stock, and then the stock becomes worthless in 2012 before you have paid the taxes, you'll have a problem with the IRS. The worthless stock will give you a $1M capital loss in 2012, but you cannot deduct your 2012 loss from your 2011 gain.
Wiki David Grabiner
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Re: ETFs vs index funds for taxable and tax deffered account

Post by Eden »

I respectfully suggest that you read The Four Pillars of Investing by William Bernstein. The four pillars are defined as The Theory of Investing, The History of Investing, The Psychology of Investing and the Business of Investing.

I do not know what your investment goal is but the portfolio you present ignores the "ultimate object of a successful investment strategy, to minimize your chances of dying poor."
Regards,
Wick
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