Who has the cheapest funds? It’s more complicated than you think

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MFInvestor
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Who has the cheapest funds? It’s more complicated than you think

Post by MFInvestor »

Interesting article by Mark Hulbert today

Who has the cheapest funds? It’s more complicated than you think --Expense ratios don’t tell the whole story

http://www.marketwatch.com/story/who-h ... 2017-03-13

He points to three different things to look at when comparing Fidelity and Vanguard Index 500 offerings.

Expense Ratio
Tracking Error
Tax Efficiency

CHAPEL HILL, N.C. (MarketWatch) — Are Vanguard’s index funds the cheapest?

The answer turns out to be far more complex than you might imagine.
For decades, Vanguard has consistently been the low-cost index fund provider. Few others came close to matching its rock-bottom fees.

Consider the difference in tracking errors between the Vanguard and Fidelity versions of an S&P 500 index fund. (For those investing a minimum of $10,000, the Vanguard fund has a ticker of VFIAX, +0.07%  and an expense ratio of 0.05%. Fidelity’s ticker has a ticker of FUSVX, +0.06%  and an expense ratio of 0.045%.) According to Morningstar, the Fidelity fund’s tracking error over the last three years has been 2 basis points, while Vanguard’s has been one basis point.

A potentially larger cost of ownership affects investors in taxable accounts: the tax impact of a fund’s trading activities. To the extent a fund is more “tax efficient,” investors in taxable accounts will pay less in taxes.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by livesoft »

The article does not explain "tax cost ratio" and left me with the impression that I am paying a huge tax cost with the funds compared, when in fact I pay no tax cost on such funds. Hulbert could have added a sentence or two to help folks better understand what tax cost was. His attempt at this was lame.

For instance, the paragraph quoted below does not even mention one of the main factors: The taxpayer's income tax rates.
Tax efficiency is a complex function of many factors, such as the portfolio’s turnover rate and how many tax loss carry forwards a fund has, but as a general rule funds that are larger and have been around longer are at least potentially able to be more tax efficient.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by sschullo »

Let me get this straight, the 1 basis point tracking error and .29% trading difference between VG and Fidelity index funds makes this more "complicated than you imagined?" Seriously? Darn, I thought I had this figured out.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by HomerJ »

MFInvestor wrote:Tax Efficiency
Index funds are super tax efficient for a simple reason. The S&P 500 and other indexes don't usually pull successful companies off their list. It's usually only failed companies that get removed from the S&P 500, etc. So they remove the ones with losses, and not the ones with big gains.

Capital gain taxes have been zero as far back as I can remember on Vanguard's big index funds.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by lack_ey »

HomerJ wrote:
MFInvestor wrote:Tax Efficiency
Index funds are super tax efficient for a simple reason. The S&P 500 and other indexes don't usually pull successful companies off their list. It's usually only failed companies that get removed from the S&P 500, etc. So they remove the ones with losses, and not the ones with big gains.

Capital gain taxes have been zero as far back as I can remember on Vanguard's big index funds.
The point, explained poorly in the article, is that different index funds may have appreciably different tax efficiency, with potentially larger impact than the ERs if close. The Vanguard index funds are better in taxable accounts because they have ETF share classes to siphon off appreciated shares to APs during the creation unit redemption process.

What you mentioned applies across many index funds but doesn't explain differences between Vanguard and Fidelity's, for example.

The article also doesn't explain anything about securities lending revenue as a part of returns, or that tracking error is calculated net of expenses and thus it doesn't make much sense to compare tracking error between funds relative to ER. It also probably didn't realize that the Fidelity ERs used to not be as low, and have changed over the comparison period.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by Epsilon Delta »

It's a complicated question because it's the wrong question. Both of them are cheap enough.

I got most of the advantage of low expense ratios when I switched to investor shares of the 500 Index in 1990. The changes since then are nice, but compared to the initial savings they are rounding errors.
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Marketwatch: who has the cheapest funds? It's complicated

Post by rolandtorres »

[Merged rolandtorres' topic and its replies into this existing thread - moderator prudent]

http://www.marketwatch.com/story/who-ha ... 2017-03-13

any thoughts on factoring tracking error with ER?
Consider the difference in tracking errors between the Vanguard and Fidelity versions of an S&P 500 index fund. (For those investing a minimum of $10,000, the Vanguard fund has a ticker of VFIAX, -0.34% and an expense ratio of 0.05%. Fidelity’s ticker has a ticker of FUSVX, -0.32% and an expense ratio of 0.045%.) According to Morningstar, the Fidelity fund’s tracking error over the last three years has been 2 basis points, while Vanguard’s has been one basis point.

That might not seem like a lot, but it’s bigger than the half-basis-point margin by which FUSVX’s expense ratio beats VFIAX.
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Re: Marketwatch: who has the cheapest funds? It's complicated

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Re: Marketwatch: who has the cheapest funds? It's complicated

Post by Northern Flicker »

any thoughts on factoring tracking error with ER?
My view is that if you have tracking error info then that is what matters, and ER is irrelevant. Expenses not accounted for in ER are a drag on tracking ability so they still show up there.

Tracking error still does not account for how much securities lending risk is being taken to meet the tracking objective, but for most purposes it provides a reliable cost comparison and measure of fund management soundness.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by *3!4!/5! »

Epsilon Delta wrote:It's a complicated question because it's the wrong question. Both of them are cheap enough.
Huh? Isn't the whole point that these funds can actually be quite different. Even if the ER difference is a basis point or two, other differences can be much bigger, tens of basis points, which over many years can be a lot.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by triceratop »

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Re: Who has the cheapest funds? It’s more complicated than you think

Post by Epsilon Delta »

*3!4!/5! wrote:
Epsilon Delta wrote:It's a complicated question because it's the wrong question. Both of them are cheap enough.
Huh? Isn't the whole point that these funds can actually be quite different. Even if the ER difference is a basis point or two, other differences can be much bigger, tens of basis points, which over many years can be a lot.
They could be quite different, but they are not. He cherry picked the time period. Leaving aside the questionable nature of the tax ratio, Morningstar show the five and ten year tax ratios for the two funds are identical. So apparently several years ago Fidelity had a lower tax cost.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by *3!4!/5! »

Epsilon Delta wrote:
*3!4!/5! wrote:
Epsilon Delta wrote:It's a complicated question because it's the wrong question. Both of them are cheap enough.
Huh? Isn't the whole point that these funds can actually be quite different. Even if the ER difference is a basis point or two, other differences can be much bigger, tens of basis points, which over many years can be a lot.
They could be quite different, but they are not. He cherry picked the time period. Leaving aside the questionable nature of the tax ratio, Morningstar show the five and ten year tax ratios for the two funds are identical. So apparently several years ago Fidelity had a lower tax cost.
Are you saying that the two funds are guaranteed to track each other as closely as the differences in ERs and that this will be true both pre-tax and post-tax for all tax payers? :oops:
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by nisiprius »

Epsilon Delta wrote:It's a complicated question because it's the wrong question. Both of them are cheap enough.
Hear, hear!
I got most of the advantage of low expense ratios when I switched to investor shares of the 500 Index in 1990. The changes since then are nice, but compared to the initial savings they are rounding errors.
Yeah. A detail that people often miss is that what matters with expense ratios are the absolute differences, not the ratios. The difference between 1.25% and 0.25% really matters, it's 1%, it's important. The difference between 0.25% and 0.05% is 0.20%, that's only one-fifth as important.

All the statistical stuff about expenses predicting performance turn out, on close examination, to mean that being one of the really expensive funds, most expensive quintile maybe, really does predict underperformance. But the differences, within, let's say, funds that Morningstar officially classifies as "low cost," don't really.

The only obvious exception is Vanguard share classes. Yes indeed, you can predict quite accurately that in any given year Admiral shares will outperform Investor shares. But fussing about a difference of, say, $110/year in a holding that can jig up and down by more than $1,000 per day is... probably misplaced.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by Jack FFR1846 »

Now, I don't quite understand the "badness" of tracking error. Let's say that the fund doesn't hold quite enough of company XYZ. Company XYZ's CEO is found to have skipped town and gone to Russia with his 22 year old secretary and a bunch of classified documents needed to run the company. The company stock goes in the toilet and the fund escapes this fiasco. So in that case, the tracking error is good for the fund? Do I understand this correctly?
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by nisiprius »

Jack FFR1846 wrote:Now, I don't quite understand the "badness" of tracking error. Let's say that the fund doesn't hold quite enough of company XYZ. Company XYZ's CEO is found to have skipped town and gone to Russia with his 22 year old secretary and a bunch of classified documents needed to run the company. The company stock goes in the toilet and the fund escapes this fiasco. So in that case, the tracking error is good for the fund? Do I understand this correctly?
Go back to first principles. Why do you want an index fund in the first place? The answer is that some people don't. They want to beat the index. The only way you can beat the index is to be different from the index. Therefore, people who want to beat the index should prefer actively managed funds... or "enhanced index funds" like Fidelity's which uses "computer-aided, quantitative analysis to select stocks that may have the potential to provide a higher total return than that of the Russell 1000 Value Index..." or "fundamental" indexes... or "smart beta" funds.

People who choose index funds do so because their goal is to match the index.

The closer the fund tracks the index, the better aligned it is to their goal. Therefore, the better it is. A index fund with tracking error in either direction is worse because it is not doing what they want it to do.

Think of it this way. Suppose your doctor has told you to take 81 mg of aspirin every day. A consumer company tests two brands.

They find that in brand X, every single tablet in the bottle contains 81 mg.
They find that in brand Y, some tablets contained 71 mg, some contained 81 mg, and some contained 91 mg.

Which is better? Brand X.

Suppose you are told that a ±10 mg error isn't a health risk and that it evens out over time. Brand X still is better.

Suppose you are told that the tablets in the bottle of brand Y that was tested actually averaged 82 mg, more than Brand X. Brand X still is better.

Because Brand Y is only close to what the doctor ordered, and Brand X is exactly what the doctor ordered.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by Epsilon Delta »

*3!4!/5! wrote:
Epsilon Delta wrote:
*3!4!/5! wrote:
Epsilon Delta wrote:It's a complicated question because it's the wrong question. Both of them are cheap enough.
Huh? Isn't the whole point that these funds can actually be quite different. Even if the ER difference is a basis point or two, other differences can be much bigger, tens of basis points, which over many years can be a lot.
They could be quite different, but they are not. He cherry picked the time period. Leaving aside the questionable nature of the tax ratio, Morningstar show the five and ten year tax ratios for the two funds are identical. So apparently several years ago Fidelity had a lower tax cost.
Are you saying that the two funds are guaranteed to track each other as closely as the differences in ERs and that this will be true both pre-tax and post-tax for all tax payers? :oops:
There is not guarantee. But you can't predict which one will have the better tax ratio over the next ten years.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by Jack FFR1846 »

nisiprius wrote:
Jack FFR1846 wrote:Now, I don't quite understand the "badness" of tracking error. Let's say that the fund doesn't hold quite enough of company XYZ. Company XYZ's CEO is found to have skipped town and gone to Russia with his 22 year old secretary and a bunch of classified documents needed to run the company. The company stock goes in the toilet and the fund escapes this fiasco. So in that case, the tracking error is good for the fund? Do I understand this correctly?
Go back to first principles. Why do you want an index fund in the first place? The answer is that some people don't. They want to beat the index. The only way you can beat the index is to be different from the index. Therefore, people who want to beat the index should prefer actively managed funds... or "enhanced index funds" like Fidelity's which uses "computer-aided, quantitative analysis to select stocks that may have the potential to provide a higher total return than that of the Russell 1000 Value Index..." or "fundamental" indexes... or "smart beta" funds.

People who choose index funds do so because their goal is to match the index.

The closer the fund tracks the index, the better aligned it is to their goal. Therefore, the better it is. A index fund with tracking error in either direction is worse because it is not doing what they want it to do.

Think of it this way. Suppose your doctor has told you to take 81 mg of aspirin every day. A consumer company tests two brands.

They find that in brand X, every single tablet in the bottle contains 81 mg.
They find that in brand Y, some tablets contained 71 mg, some contained 81 mg, and some contained 91 mg.

Which is better? Brand X.

Suppose you are told that a ±10 mg error isn't a health risk and that it evens out over time. Brand X still is better.

Suppose you are told that the tablets in the bottle of brand Y that was tested actually averaged 82 mg, more than Brand X. Brand X still is better.

Because Brand Y is only close to what the doctor ordered, and Brand X is exactly what the doctor ordered.
I follow what you're saying. I still don't see that the amount that a fund doesn't track the index is a bad thing. From my thinking, I look at it sort of how I look at rebalancing. I do it once a year and as far as I'm concerned, that's good enough to keep my AA in line. I know some target date funds rebalance every day. While the target date fund would be closer to the AA, if my portfolio went more away from target but I rebalanced at a time when one asset is very high and the other very low, perhaps I'd do better, having waited.

I suppose that my approach has a lot to do with why I don't feel that tracking error is all that bad. I choose US Stock funds and ETFs based on being market weighted, large number of stock funds. I use several interchangably without really worrying if they're right on top of the index or not. Total US Market and S&P 500 at Fidelity, SCHB and SCHX in Schwab and soon to buy VTI at TDAmeritrade.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by ruralavalon »

Tiny differences in expense ratio (a few thousandths or a couple of hundredths of a percent) mean almost nothing. The expense ratio difference can be overwhelmed by differences in:
1) tracking error;
2) tax-efficiency;
3) policy on securities lending; and
4) any difference in the index used.

As I understand it Morningstar's "tax cost ratio" information is in error, for not considering the difference between qualified and non-qualified dividends.

Recent expense ratio changes by Fidelity and Schwab are surely welcome, but are certainly just their attempt to secure bragging rights and a marketing advantage.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by House Blend »

Pfft. Yes, the discussion of tax efficiency was weak.

To me, the most glaring flaw in the article was not the YMMV aspect of taxes, but rather the absence of any mention of cap gain distributions.

Vanguard stock index funds (that have an ETF share class) including VFIAX generally do not distribute cap gains.

Fidelity's FUSVX distributed about 0.5% last year. (I don't know enough of the fund history to say whether this is typical.) If we assume all of the gains distributed were LT, that's an extra 7.5 basis points in Fed tax costs for someone who pays 15% on LTCG.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by Epsilon Delta »

nisiprius wrote: Think of it this way. Suppose your doctor has told you to take 81 mg of aspirin every day. A consumer company tests two brands.

Because Brand Y is only close to what the doctor ordered, and Brand X is exactly what the doctor ordered.
Except you need to consider why the doctor ordered 81 mg. It's not because it's the physiologically optimal dose. Probably nobody knows what the optimal dose is, and if they do it's most likely not 81 mg, and it's certainly not 81mg for both me and my wife, who is quite a bit smaller. It's because 81 mg aspirins are readily available. If there is a measurable, or even theoretical, difference between 81mg and 82mg doses it's just as likely 82 mg is better.

For funds the keys are wide diversification and low expenses. Index funds deliver these and the expense ratios are so low and diversification so wide that nothing will be much better. But it is possible that some other fund has a tad less diversification, a positive tracking error and lower expenses is a fraction of a wee bit better by whatever metric is capable of measuring that gnats eyelash.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by TimeRunner »

Quick amusing Aspirin backstory: It's 81mg because the foundational study was done by cutting a regular 375mg tablet in quarters. No one spent the money to test 91 vs 81, etc. :D
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by Fundhunter »

I have been seeing the new Charles Schwab mutual fund ad on television for the last few days. It is a follow up to the ads that try to shame the full service brokers and their high trading fees. This new one pushes the Schwab Index 500 mutual fund (SWPPX), saying it is cheaper than Fidelity and Vanguard with no minimums. It says its fund (and I confirmed on the website) has a .03 expense ratio, while Vanguard has .14 (Odd, because I looked on the Vanguard site and they list Investor Shares at .16). Of course what the ad doesn't say is if you have over 10K in Vanguard Index 500, then you can convert to Admiral Shares, with .05 ER.

I think all these differences are so small that they are essentially not relevant. I will stay at Vanguard, in spite of paying .02 more in expenses. I don't really care about tracking error, which could cut either way, but likely not in any significant way.

However, I think it is great that Schwab is getting competitive with Vanguard on expenses. Maybe they woke up and took notice which mutual fund company sat at the top......and they figured out why!
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by whomever »

We have both FUSVX and VFIAX (on the 'not all eggs in one basket' theory).

Theory aside, if you run a morningstar growth chart since the inception, the two lines are pretty indistinguishable. I think VFIAX is ahead by 2% or so after 30 or so years - your original $10K has become either 166980 or 170474. So there's a difference, but not a lot.

I haven't looked in detail, but my sense (simply by doing my taxes evary year) is that FUSVX usually throws off a little more in taxable income each year (ISTR threads here about how having a twinned ETF gives Vanguard some advantage WRT taxes??).

I don't disagree with the points the article makes, but perhaps these two funds aren't the best example of why the differences matter. If someone managed to get the performance of VGHAX while throwing off less taxable income that would be interesting.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by sungchiahao »

Is there a summary of the index mutual fund tax efficiency, tracking error, or the security lending? I looked on M* but I'm not seeing it. Do I need to be a premium member to access those information?
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by ruralavalon »

sungchiahao wrote:Is there a summary of the index mutual fund tax efficiency, tracking error, or the security lending? I looked on M* but I'm not seeing it. Do I need to be a premium member to access those information?
I rethink that there is such a summary anywhere.

Discussions on this forum are probably the closest that you will find. There have been several discussions along these lines.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by Northern Flicker »

I follow what you're saying. I still don't see that the amount that a fund doesn't track the index is a bad thing.
While there have been some visible misses on index tracking by a large index fund due to investments not tracking the index (BND by Vanguard and EEM by ishares come to mind), almost all tracking error for major index funds is accounted for by expenses being a drag on returns, and securities lending revenue and index arbitrage revenue (if index fund managers still practice arbitrage of index holdings against futures contracts) enhancing return.

Favorable tracking error is not typically the result of lucky active decisions, but because securities lending (and possibly index arbitrage) revenue exceeded expenses.

Because substantial expenses and auxiliary revenue are not transparently accounted for in expense ratio, tracking error is (barring the rare but not non-existent investment tracking errors) a useful measure of net cost.
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Re: Who has the cheapest funds? It’s more complicated than you think

Post by nobodyimportant »

i don't sell vanguard shares. so i don't worry about any form of big capital games.
dividends are qualified on most vanguard index funds.
if you retire with over 500k in qualified dividends a year you will pay 25% I think. for 2017.
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