21 Jan Furnishing Your Portfolio with ETFs and Mutual Funds
My colleague recently explained how he moved from a furnished apartment to an unfurnished one, requiring him to get some furniture.He thought about renting because there was a chance he might move back into a furnished apartment sometime in the future. He decided to buy instead. How long he planned to stay in this apartment was a deciding factor. He calculated that the monthly costs of renting the furniture would exceed the upfront costs of buying the furniture at some point in the future.
Time horizon is an important factor when it comes to investing too, especially as it pertains to implementation costs. Once you’ve decided on a specific portfolio strategy, the next step is implementation.Choices include ETFs and mutual funds, which are subject to two main types of costs:
Transaction costs,which occur at a point in time, include bid-ask spreads and upfront fees or commissions.
Ongoing costs,which occur gradually over time, include expense ratios and taxes.
Because these costs occur at different points in time, the expected time horizon can favor one vehicle over another, not too dissimilar to the furniture purchase decision. Figure 1 summarizes a hypothetical transaction cost/ongoing cost analysis for a mutual fund versus an ETF. The analysis makes a few assumptions, including that gross return expectations for both products are similar and that the transaction is a onetime purchase in which differences in return lost to taxes are not incurred (meaning expense ratio is the only ongoing cost).
Scenarios 1 and 3 yield straightforward conclusions because one product has the lower expense ratio and the lower transaction costs, giving it a clear advantage over the other. In these scenarios, no breakeven holding period analysis is required.
Scenarios 2 and 4 yield a less straightforward conclusion because no clear cost advantage exists. For example, in scenario 2, the mutual fund has a lower expense ratio but higher transaction costs. This means the mutual fund is more costly as soon as the purchase is made, but because it has a lower expense ratio, it eventually “catches up” to the ETF and becomes less expensive in terms of total costs over a specific time horizon. In these scenarios, a breakeven period analysis is required to determine just how long it would take one product to catch up to the other.
Fortunately, there’s a quick formula investors can use to determine breakeven holding period when no clear cost advantage exists:
TC1 and ER1 refer to transaction cost and expense ratio, respectively, for product 1.
TC2 and ER2 refer to transaction cost and expense ratio, respectively, for product 2.
How do you use the formula? For a quick tutorial, I can provide an example similar to scenario 2 above. Let’s say product 1 is a mutual fund, and TC1 and ER1 equal 2 and 8 basis points(bps), respectively, while product 2 is an ETF, and TC2 and ER2 equal 0 and 20 bps, respectively.
The breakeven period (in years) would be:
2 – 0
20 – 8
This equals 1/6 of a year, roughly 8 weeks. In other words,the mutual fund costs more initially, but after eight weeks, it costs less overall because of expense ratio savings. Thus, an investor expecting to hold this investment for more than 8 weeks may prefer the mutual fund to the ETF.
A more thorough review of selection considerations (and the math behind the formula) can be found in our new paper, Choosing between ETFs and mutual funds. Breakeven analyses like this are not so different from the purchasing decisions we make on a daily basis, where our expected time horizon can be an important factor, even when deciding between buying or renting furniture. When it comes to investing, making decisions with the time period in mind can help you save costs and ultimately bring you closer to your investment goals.
Jim Rowley, Senior Investment Analyst of Vanguard Investment Strategy.
© 2016 The Vanguard Group, Inc. All rights reserved. Used with permission.