It took some three decades and a financial crisis, but the evangelicals of index investing finally got their message across—low fees lead to better performance.
The past decade has seen unprecedented amounts of money going into index funds. And not just any index funds, but the very cheapest: More than 97% of flows into the $4 trillion exchange-traded fund industry last year went to ETFs that charge 0.2% or less, Bloomberg data shows.
Except some new research indicates that cheaper isn’t always better. That new message is coming from an unusual corner—noted Vanguard expert Dan Wiener, editor of the Independent Adviser for Vanguard Investors and chairman of financial advisory firm Adviser Investments.
“Vanguard’s late founder, Jack Bogle, had it wrong when he said that investors always ‘get what they don’t pay for.’ Sometimes they don’t,” he tells Barron’s. Of course, Bogle wasn’t referencing ETFs, but the performance of Vanguard’s mutual fund share classes versus their ETFs is illuminating, Wiener contends.
Vanguard’s funds require a bit of an explanation. The $5.3 trillion money manager has a unique exception, enabling it to launch an ETF as a share class of an existing mutual fund, so both have the exact same holdings and strategy. Other firms must introduce a whole new fund with an ever-so-slight difference in holdings. This makes performance comparisons difficult—whether you’re weighing an ETF against a similar, but not quite exact, mutual fund, or against another ETF with a similar, but not quite identical, index as its basis. The exception is the handful of BlackRock (ticker: BLK), Vanguard, State Street Global Advisors , and soon JPMorgan Chase (JPM) ETFs that track big indexes, such as the S&P 500 or the Barclays Aggregate Bond Index.
“It is exceedingly rare to be able to compare ETFs, apples-to-apples. You can’t hold all else equal, which underscores the fee obsession,” says Ben Johnson, director of global ETF research at Morningstar.
Because of the quirk, however, the performance of the portfolios in Vanguard’s ETFs and mutual funds can be compared directly. The firm’s Institutional Plus share class, which has a buy-in of $100 million, has the lowest fee. Admiral shares used to be the next cheapest, but Vanguard’s latest annual report shows that the ETF prices below Admiral shares—though we’re talking about a difference of maybe 0.01%. The firm also lets Admiral share class investors exchange their holdings for an equivalent ETF.
One might think that the share classes advertised as having lower fees would produce better results if both had the same holdings. But that’s not always the case.
Consider the Vanguard Total Stock Market Index fund. In the 10 years through 2018, the Admiral shares (VTSAX) returned 13.25% annually; the ETF (VTI), 13.26%. The ultracheap Institutional shares (VSMPX) did even better, rising 13.31%. That’s to be expected. However, the ETF also returned more than the previously pricier Admiral shares net asset value over certain periods in those 10 years. All the differences were only a matter of basis points—each equal to 0.01%, or just a dollar for every $10,000 invested—but they still might puzzle some investors.
Wiener, who shared with Barron’s how a real portfolio of Vanguard funds performed in his Roth IRA, noted that his return on the ETF shares differed from Vanguard’s stated return on market price—that at which you can buy or sell ETFs, which, in turn, differs from the NAV. Vanguard calculates the market price by taking the midpoint of the bid-ask spread for the trading cost of the ETF.
Why? Well, trading ETF shares involves more variables than buying and selling mutual fund shares. As a result, no ETF trade is done exactly at NAV and depending on when and how it’s executed, an investor could pay more or less than the next person.
A buy-and-hold investor like Wiener, who purchased the ETF at launch in 2008, never doing anything subsequently except reinvesting dividends, might find his real return differing by a few basis points from that reported on Vanguard’s website, because of the trading cost variable. In contrast, open-end mutual funds always change hands at NAV. Thus, gripes: “When you go to sell, how do you know you’ll get as much for your shares as someone who sells at NAV in an open-end mutual fund?”
Rich Powers, the head of ETF product management at Vanguard, says that the price differences “could be a function of penny rounding, which might present as such that one product has outperformed. “It’s a theoretical possibility.”
While the difference in performance is only a few basis points, Wiener says: “Isn’t the whole conversation around fees about basis points?” Indeed, as most investors know, a few basis points more can add nicely to the value of an investment held for many years.
Write to Crystal Kim at firstname.lastname@example.org