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On ETFs - Another View (Post to IndexFunds.com Discussion Board from UwchlanGuy)

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First, I want to emphasize that I am a very happy Vanguard investor, and would love to find a hole in this analysis. Or, for it to be right and nudge Vanguard into shaving down the differential that I am seeing.

Small-cap funds would seem to be an area where ETFs might have the best chance of beating Vanguard's funds, since:

· Vanguard's Small-cap funds charge 0.5% purchase fees, adding to upfront costs
· Small-cap funds tend to have high cap gain distributions, due to stocks outgrowing the index

Making the comparison potentially less messy is the fact that there are iShares products tracking the same indices as VG SmallCap (R2000), SmallCap Value (S&P SC600/Barra Value), and SmallCap Growth (S&P SC600/Barra Growth), and these have the same expense ratios (0.25%) for both Vanguard and iShares.

I set up an Excel spreadsheet with the following scenario:
· Starting investment of $1000
· $1000 to invest each year, but any expenses (taxes, holding fees, etc) come out of this first
· iShares purchased through Vanguard Brokerage Services - $20 transactions & no account fee
· No $10 <$10K fee on the VG fund; assumes either are adding to an existing account with >$10K or have total VG assets >$50K
· VG purchase fee of 0.5% (doesn't apply to reinvested distributions)
· Bid/Ask & NAV discount cost of 0.3% for iShares (roughly based on Salomon Study which is detailed in an October 23, 2000 article on IndexFunds.com
· Expense ratio of 0.25% for both
· All capital gains reinvested
· VG cap gain of 5% NAV/year (roughly from VG's estimates; SC is predicted to have 12%, SC-G 5%, and SC-V 3%).
· iShares cap gain of 0.5% NAV (estimated from Barclays' estimates ; SC (IWM) is predicted to have no distribution this year; small-cap growth (IJT) 0.61% and small-cap value (IJS) 0.02%)
· Capital gains taxed at 45% -- high fed bracket high state tax rate. This does assume that all capital gains are short-term; I would guess that for Vanguard some gains will be long-term and taxed lower (perhaps for both fed & state)
· Both funds have same appreciation, 8% each year (assumes that Barclays' indexes as well as Vanguard)


First question is what's wrong with the above list? Anything missing? Are any of these values unrealistic? Are the low iShares capital gains distribution estimates a fluke due to this being the first year (did they go through as many index reconsitutions during the year as the Vanguard funds did?)

Second question is whether I got the formulas right.


Year iShares Vanguard
Initial $977 $995
1 $1,766 $1,777
2 $2,600 $2,593
3 $3,481 $3,443

After 12 years, iShares are ahead by $1,170, which is 9.1% more than the VG total of $12,874.

If this analysis is correct, then Vanguard is in danger of losing a lot of business to the ETFs. Of course, one alternative not considered here is Vanguard's Tax-Managed SmallCap fund. However, that would still leave iShares ahead in the segment areas.

Additional Response from iShares Partisan New Arrival on IndexFunds.com Discussion Board:

You don't specify the funds used in the comparison. There ARE differences between the Vanguard and iShares small cap fund offerings, in particular with respect to expense ratios. There are six iShares small cap funds:

Small Capitalization Funds - Average Expense Ratio (0.23%)
iShares S&P SmallCap 600 IJR (0.20%)
iShares S&P SmallCap 600/BARRA Growth IJT (0.25%)
iShares S&P SmallCap 600/BARRA Value IJS (0.25%)
iShares Russell 2000 IWM (0.20%)
iShares Russell 2000 Growth IWO (0.25%)
iShares Russell 2000 Value IWN (0.25%)

As you can see, for iShares S&P 600 and iShares Russell 2000, the expense ratio is actually .05% cheaper than the comparable Vanguard portfolio.

- Your starting investment amount ($1,000) works for a mutual fund where fractional shares can be bought, but leaves uninvested cash when ETFs are employed. It also exaggerates commission rates. IWM, for example, is a $90 stock. Before expenses, $1,000 gets you 19 shares, leaving $10 uninvested. What's uninvested doesn't earn the index return. And the implied commission rate becomes $20 divided by 19 shares, or $1.05/share. That's awfully rich. Most stock transactions are done in round lots. Per the VBS schedule, that makes the more typical rate $.20/share.

- You've factored in a 'cost' of 0.30% for the bid/ask spread and the 'discount' from intraday portfolio value per the Salomon study. You're only buying in this scenario. When buying, a discount would be a benefit, not a detriment; you'd actually be buying assets cheaper than their intrinsic value. It'd only be a 'cost' when selling. ETF returns are based upon trading prices (cost basis and sale proceeds), just as with conventional funds. In a conventional fund, of course, all trading takes place at NAV. I'd drop the bid/ask spread from your calculations. After all, the discounts taken from what? Unless you're an institutional investor, you can't buy at the intraday portfolio value; you don't have enough capital to buy the whole portfolio.

- Turnover in the S&P 600 index was high this year - about 112 names were swapped in the benchmark since the beginning of the year. iShares S&P 600 was launched on May 26; the potential turnover is 60 names in the iShares S&P SmallCap portfolio through November 28. But the iShares portfolio was seeded with these stocks for a presumably shorter time. Although it followed a ragged course, the small cap market is now higher than it was in May. It's likely the cost basis of the stocks in the iShares portfolio would be higher than that of the names in the Vanguard fund. That'd mean, all things being equal, lower cap gains at turnover. Even if both portfolios follow a full replication methodology (and at least one does not), there can still be variances in cost bases and sale proceeds as the portfolio managers try to 'game' the rebalancings. (Russell indexes, of course, are reconstituted only as of June 30).

Comment By Jim Wiandt
This is an interesting analysis that hits open-ended funds in one of their weakest areas: tax efficiency. In addition, in this comparison, ETFs have the additional advantage of going head to head with some of the few Vanguard funds that charge an asset-based fee upfront - essentially a load of 0.5%. All this said, it is fascinating to note that this analysis holds that ETFs can conceivably even come out to be a better buy with what is essentially a dollar-cost averaging strategy.

In some areas, the analysis, as noted by New Arrival, may be unduly kind to the Vanguard funds:
1) First of all he assumes that this small investor meets Vanguard's requirements for fee waiver, that is, that he has either $10,000 in the fund or $50,000 total in Vanguard funds. For someone who fails to meet those minimums there could be an additional $10 to $20 annually.
2) We've got to compare apples to apples here. Some of the iShares small-cap funds actually do have lower expense ratios than the equivalent Vanguard funds.

In other respects, New Arrival's additions in his response show a clear bias toward the iShares funds.
1) In this analysis, as in Vanguard's, commissions are an issue. I don't think it's unreasonable to assume a commission of $20 or less. I DO think it is unreasonable to assume a commission of $3.80 on a $1,000 trade, which is essentially what New Arrival does in disputing the calculation ($0.20/share X 19 shares).
2) While he quibbles with a 0.30% "cost" as he puts it paid for ask/bid differential and NAV premium/discount, New Arrival fails to note that in actuality, this number from the Salomon study refers only to the premium/discount and not the ask/bid, which is estimated in the Vanguard study to be between about 2 and 9 additional basis points in the highly priced S&P 500 funds (which would translate to 3 to 13 basis points for the iShares Russell 2000 for example)
3) The difference in capital gains distributions is significant and they would bear examination over a longer period of time for the new iShares. While there are strong tax advantages of ETFs in the lack of gains paid on redemptions, and in the ability to shed low-cost-basis stock, distributions still must be paid on index rebalance.