Frugality With Pizzazz, If You Want

Lynn O'Shaughnessy
Posted: Jan 02, 2006 9:20 AM

Who would ever think of spreading caviar on a hot dog? Or dropping a Rolls-Royce engine into a Toyota Corolla? Of course, this isn't remotely practical, but these sorts of upgrades - if you can call them that - are making inroads into the world of index investing, the plainest Jane of investment strategies.

Today, for instance, you can invest in a curious index that tracks 30 American food and beverage companies. You can now binge on saturated fat and invest in it, too. You can also index your way through the Rand McNally Atlas by dabbling in the stock markets of countries you'd never want to visit.

One reason why investors can wander easily down some of Wall Street's more curious back alleys is because of the emergence and popularity of exchange-traded funds. These funds can be invaluable investment tools, but if you hang out with the wrong ones or use them in inappropriate situations, your portfolio could get hijacked.

An exchange-traded fund looks and behaves very much like an index mutual fund. You could say that one's a Labrador retriever, and the other's a golden retriever. Like an index fund, an ETF holds stocks or bonds in its portfolio that replicate its underlying benchmark. An investor in the Vanguard 500 Index Fund, the nation's most popular index fund, owns shares in the 500 blue chips in the Standard & Poor's 500 Index. You'd own the identical stocks if you invested in two popular exchange-traded funds - iShares S&P 500 Index or the Standard & Poor's Depository Receipts Trust, which most people call by its abbreviation - SPDR (pronounced spider). The point of ETFs and index mutual funds is, of course, to capture the market average of whatever you want to invest in, whether that's stocks or bonds. If you index by either method, you should fare better than the vast majority of investors.

One of the most endearing traits of the exchange-traded fund is its frugality. Investing in ETFs is the equivalent of pushing a shopping cart down the aisles of a 99-cent store. Exchange-traded funds are priced far more reasonably than the average actively managed mutual fund. The annual expense ratios for ETFs dip as low as .07 percent. In contrast, the average actively managed mutual fund sports an expense ratio of roughly 1.4 percent. The pricing difference might seem like a big so-what, but it can mean the difference between retiring with seven figures versus six.

Here's one example of why ETF pricing is so desirable: Suppose you've got $100,000 sunk into the cheapest ETF and it generates 8 percent annual returns. If you sit on this investment for 20 years, it would grow to $459,613. In contrast, the average-priced mutual fund, which is handicapped by its higher costs, would only reach $351,571. The best index funds, by the way, are also priced cheaply, but you must beware of expensive imitators that have infiltrated the marketplace in recent years.

Investors also adore the exchange-traded funds for their built-in tax advantages. Because of the way they are structured, most ETFs are incredibly tax efficient. For example, ETFs very rarely make capital gains distributions, which are as welcome as termites and can seem just as hard to eradicate. When a mutual fund distributes capital gains, hapless investors must pay taxes on this money, even though they haven't cashed in their shares. And these "gains" are strictly ephemeral. Sure, you technically get to pocket gains, but the value of your holdings are reduced by the same amount so it's a wash, except you pay taxes on this wash.

ETFs are clearly more tax efficient than your typical mutual fund, but how do they stack up with index funds? In the tax arena, conventional wisdom suggests ETFs can easily out-arm wrestle index funds. Jim Wiandt, the editor of the Journal of Indexing, however, recently explored whether he could poke holes in this conventional wisdom. He compared the tax efficiency of the SPDR, the granddaddy of all ETFs, with the average S&P 500 index mutual fund. Specially, he looked at the SPDR's capital gains distributions since 1993 versus its indexing competitors. As it turned out, conventional wisdom was in no danger. During the time period, the SPDR only distributed capital gains one year, and it was minuscule. In contrast, the average index fund distributed capital gains every year.

But frankly, just looking at the tax profile of the typical index fund isn't completely fair because so much indexing cash is tied up in just one fund - the Vanguard 500 Index Fund.

Consequently, Wiandt also compared the cap gains distributions of the average S&P 500 index funds with the Vanguard titan. The average funds lost in another lopsided battle. What was more intriguing is what happened when the Vanguard fund and the SPDR faced off. As it turned out, the mutual fund distributed a wee bit more in capital gains, but despite this handicap, it eked out a slightly higher return than the SPDR from 1995 to 2004.

The Vanguard 500 Index Fund enjoyed annual returns of 13.92 percent versus 13.83 percent. You can see Wiandt's study, "Putting the ETF Tax Efficiency Debate to Rest," by visiting IndexUniverse at and clicking on the features section.

If you're an investor, the obsession with tax efficiency is going to be irrelevant if you've got all your money tied up in tax-protected retirement accounts. It's only going to matter if you've got taxable cash. Consequently, ETFs are more attractive if you're trying to shield money from Uncle Sam.

ETFs won't be a realistic option for investors who dollar-cost average. The reason is because exchange-traded funds trade like stocks. So if you want to purchase a stake, in say, iShares S&P SmallCap 600 Index, you'd have to go through a brokerage firm and pay a commission for every trade.

The brokerage commissions would gnaw at your returns. For anyone feeding money into their accounts regularly, an index mutual fund is a better choice because you can invest directly with the fund family without incurring any trading costs.

If you're looking to invest a large chunk of change, ETFs, as well as the cheapest index funds, can be a great alternative for gaining exposure to the major asset classes, such as large and small domestic stocks, foreign stocks and even bonds. What you want to avoid are all the kooky exchange-traded funds that hand investors an opportunity to chase their dumb hunches. I'd lump into this category pretty much all sector ETFs that let you invest in small slices of the market, such industrial materials and energy, as well as ETFs devoted to individual foreign countries. Frankly, there's no compelling reason to park cash in an ETF linked to Malaysian stocks or junk food.