Learn how and when to add ETFs to your portfolio

Vanguard investing experts Rich Powers and Josh Hirt describe how and when to add ETFs to your portfolio.

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Talli Sperry: Okay, great. So how do we start to think about this pricing piece? I think you’re mentioning they change throughout the day; we need a little bit more education; we may get different prices. What level of control, for lack thereof, do we potentially have as investors here?

Rich Powers: As far as executing, right? So as Josh alluded to, I think the ETF does put a little bit more onus on the investor towards the decisions they’re going to make. When you’re executing a trade, you have the ability to use a market order, which allows you, basically, to get your order executed as quickly as possible. You’re not that interested, not that concerned with the price that you receive; you just simply want to be in the market. You could also use a limit order, and in that case, you are really focused on the price that you achieve when your order goes to market. And so, perhaps, it takes a while for that order to be filled because the price range of the ETF isn’t where the limit order is that you’ve placed. And so, that’ll be a key difference—and perhaps a responsibility experience difference—that ETF offers relative to, say, a mutual fund.

Talli Sperry: So, again, it’s about knowing what we want. Do we want to be in or do we care about a certain price point, right?

Rich Powers: That’s right.

Talli Sperry: Okay, great. So we have one more live question, and this one, it looks like Thomas is asking, “Are dividends and capital gains able to be reinvested automatically in the ETFs?” Josh, maybe I’ll throw that one to you?

Josh Hirt: Yes. I would come back and say that definitely these, again, focus on the key parts of ETFs and the key parts of the mutual funds that are very similar. There are many of these elements that are—whether it’s taxation or whether it’s the dividend side of things—that can be handled very similarly. In terms of investing them, you generally can reinvest those through that same process that you’d be able to have on the mutual fund side.

Talli Sperry: Okay, good. That’s good news. So we’re going to go to one of our presubmitted questions, and, Josh, this one is from Paulette in Oakland, California. And she’s asking, “What are the costs associated with ETFs?” So we started to get into this a little bit, but let’s dive further. Can you explain just how we should think about cost broadly with ETFs?

Josh Hirt: Sure. I’ll come back. ETFs and mutual funds—you’re going to have some similar costs with some potential additions. I would say the biggest comparison with both—and with ETFs you’re going to have ongoing costs and transaction costs. Ongoing costs—generally we’re talking about expense ratios. So these would be the types of costs that you will incur to run the fund: Pay salaries, rent, administration. Really, behind the scenes, what does it take to actually get the fund run both from the money management side and the administrative side of it? A lesser, maybe, thought of ongoing cost would be taxes. So something that can be a drag on the portfolio—it’s not exactly front and center, something that you can look at immediately, but it is something that will play a role in your portfolio long-term.

In terms of transaction costs, again ETFs have them; mutual funds have them. Mutual funds have them sometimes in the nature of redemption and purchase fees, and ETFs have them in the form of commissions. So you might be charged a commission when you trade an ETF, but then you also have things such as the bid-ask spread. So, really, this is a function of them trading on exchange. Again, this is, primarily, instead of investors transacting with the fund as they do in a mutual fund, in the ETF, investors are transacting on exchange with each other. So, buys and sells are being matched, and you have somebody that’s facilitating that, that is charging a fee to facilitate these trades. That’s really where the bid-ask spread comes in. So you’re paying something that is slightly different from maybe what the underlying value is, that’s as a service for matching the buys and sells.

Talli Sperry: That’s helpful, and we actually have a really good chart for you on this. So I’d love to bring that up right now if you’re okay with that. And on that note, we have Mitch asking, “Can you explain the bid-ask spread for ETFs?” So I think this is perfect timing, Mitch. We’ve got our visual for you, and then, Josh, I’m going to ask you to just walk us through a little bit, how to understand the visual.

Josh Hirt: Yes, sure. I think so. And Mitch, write back if we don’t clarify here as well, but I think part of my initial answer gets to some of that. What really is the bid-ask spread and what are you paying for? Again, it’s a function of you trading on exchange, and so, to match these orders, there is a service that’s paid for that. Essentially, looking at what out there in market is the best offer, the best that someone is willing to sell at, or the best bid, the best offer that someone is coming and saying, “I will buy this security at this price.” In between there, there is that spread that’s charged to really facilitate that.

Talli Sperry: So in our visual, the top half is that sell space you were talking about, right? And the buyer would probably be asked if we’re actually buying the ETF, and then the spread you were talking about, that middle space in the chart, that’s our bid-ask spread we keep referencing. Is that correct?

Josh Hirt: Correct.

Talli Sperry: All right. Good. So feel free to let us know if you’d like to see that visual again or if you’d like more clarity there.

Right now we’re going to jump to another live question, and this one is from Jan. And she’s asking, “Can ETFs be used in conjunction with IRAs and Roth IRAs?” So, Rich, you’re nodding at me. I’ll give that question to you.

Rich Powers: Yes. ETFs can fit the bill for really nearly every investment account you could think of. Because they’re just like mutual funds, they fit in those types of portfolios. What you would probably want to do first is think about what the investment strategy is of the portfolio that you’re choosing. So, for instance, and this is where Josh is maybe even more expert than me, but if you’re thinking about making an investment in a fixed income ETF, you probably want to think about putting that into an IRA investment because that’s tax-sheltered and there is a greater tax incidence with fixed income investments because they’re constantly paying dividends. With an equity index fund, it could fit in an IRA or could also fit pretty well in a taxable account. So, yes, ETFs have utility in nearly every account you can really think of: IRAs, long-term investment accounts for kids’ educations, or just a general taxable account.

Josh Hirt: I was just going to say, it seems like we’re getting a lot of questions about, is it appropriate for this? Is it appropriate in this instance? And I think, again, really come back and think about the two structures: we’re much more familiar with mutual funds and ETFs facilitating some very similar things. And we think about a question about retirement, one of the most important things you can get right in that scenario is your asset allocation, and ETFs can certainly be used to facilitate that in the same way.

Talli Sperry: Yes. I like where you were going both of you in this. Focus on your goals and why you’re doing what you’re doing, because at some point, it’s a little bit less about the exact vehicle that is being your first choice but really knowing why you’re doing what you’re doing being your first choice, and then the vehicle support that choice.

Josh Hirt: I think we would say that the ETF or the mutual fund or any other vehicle is a choice about implementation, not about strategy. So an ETF is not a strategy, but it is a tool for implementing a strategy.

Talli Sperry: I love that verbiage. That’s really good.

So let’s jump to one more question. This is from Richard from Chicago, Illinois, and he’s asking, “Please walk me through the mechanics of the trade and break down the different ways an order is specified.” So, Rich, you got into this a little bit with the market order and the limit order, but what more can you tell us about some of the specifics and the way those are executed?

Rich Powers: Sure. Again we’re assuming investors have done their homework and decided this is the right type of investment strategy. At that point, they’re going to go to the order path within a given brokerage firm’s platform, and they’re going to say, “Well, I value speed and execution.” And in that case, they’ll choose a market order, and that market order will go to the market and very likely be filled relatively quickly within a few minutes’ time. In the case of a limit order, that investor’s saying, “I want to be really careful about the price I actually receive for the order than I’m placing.” And so, it might take a little while for that ETF’s price to get across into that area in which the investor said, “That’s where I want to get involved.”

And so, the risk that investors run is that their order may not be filled in a given day and may kind of stretch out over a couple days, but they prioritized the price they pay over speed. And that’s perfectly acceptable. And I’d say we would generally caution investors to think about using limit orders. Actually, encourage investors to think about using limit orders over market orders given the volatility you might see in the market and in a security’s price kind of moving away from you rather rapidly.

The other thing you have to do with an ETF that you don’t necessarily have to do with a mutual fund is specify the number of shares you want to trade. So with a mutual fund, if you wanted to buy shares of a mutual fund, again coming back to our example, send your thousand dollar check in, whatever the price of that mutual fund is on the day your check arrives, that’s how many shares you get. With an ETF, you have to look at your brokerage account and say, “What’s my balance? What do I have available to spend?” And then look at the price of the ETF and identify what number of shares are you willing to purchase given what you have available. So that’s another step, not complicated, and most brokerage firms have a calculator for you on their site to allow you to quickly go through that math. But that’s a difference relative to what people are used to with mutual funds.

Talli Sperry: That’s great. And I want to go back to something you said about the price moving away from us quickly and the importance of that limit order, because for many of us, we’re cost-conscious and we know what we want to spend. So just keeping that top of mind, so things don’t move quickly beyond where you wanted them to, is really an important point I want to draw out for us.

Rich Powers: Absolutely.

Talli Sperry: Great. So let’s go to one more live question. This is from Steve—thank you—and he’s asking, “Since the spread between bid and ask is the cost of closing the deal, does the spread always stay the same or is the spread dynamic? And if it’s dynamic, what drives the change?” Josh?

Josh Hirt: It’s a very good question. Absolutely, it is dynamic. So it’s as much in the capital markets; it is extremely dependent on the environment in which we are living currently at that point in time. So it would also be affected by just overall volatility in the market. If they have something that is going on in the market—events such as Brexit, elections, geopolitical events—these are things that can certainly affect how bid-ask spreads could change, widen, narrow, etc.

Maybe a helpful way to think about the bid-ask spread as well is [that] this is the price that is being charged, essentially, for the risk that is being borne in facilitating this trade. So as environments tend to get more risky or more uncertain, that can be a scenario that causes the bid-ask spread to widen out. Even within a specific asset class, while that could be the case, you’ll have changes within asset classes in general as well. So you may see much tighter bid-ask spreads for a very liquid, very efficient asset class such as U.S. equities. That would be a different level of bid-ask spread for something such as corporate fixed income. So, absolutely very dynamic and it can change.

Certainly, there are levels that are in ranges that tend to be where things come back to, but they are dynamic and can change.

Rich Powers: It’s really important, too, to talk about that the spread of an ETF is driven by the spread of the underlying basket of securities that it represents, right? So, as Josh was alluding to, large-cap U.S. stocks probably have a tighter spread than, say, small-cap U.S. stocks because the spread of blue-chip types of companies ends up being tighter because those stocks are traded very frequently and by a wide array of market makers. And so, the ETF is always going to reflect the underlying security exposure from a spread standpoint.

And, in fact, the ETF might actually be able to give an investor tighter spreads than they would experience if they went out and bought the underlying individual securities, and that’s because, as we were talking about before, you’re not interacting with the ETF fund sponsor, right? You’re interacting with other market participants. So that level of trading that’s happening will necessitate, potentially, a tighter spread versus going out and assembling those 50, 100, 500 stocks yourself.

Talli Sperry: And it makes sense that the spread would be dynamic because you’ve got multiple parties involved, and they’re each making different decisions at different points in time, when you think of the top and bottom half of our graphic a bit ago. So that makes perfect sense. I think one thing you’re pointing out, again, is just this knowledge of the markets, and that’s the fun part of these products. You actually get into understanding the markets a little bit more broadly.

So I do want to draw you back to the green Resource widget. That was actually a really fun place for me to study a bit when I was preparing for this, and I enjoyed just all of the extra knowledge. It made these products just more exciting and more enjoyable to dive into. So I just encourage you to read there as well.

All right. So let’s go back to some of our presubmitted questions, and let’s look at Pamela from Rollinsford, New Hampshire, who’s asking, “Please discuss the tax efficiency of ETFs.” So, Rich, I’m going to give this one to you, and we made a slight allusion to it earlier. I think, Josh, you mentioned taxes a little bit. So can we elaborate?

Rich Powers: Sure. So if you were to pick up any newspaper, any kind of white paper or research article on a company’s website, what you’d see is ETFs are a tax-efficient vehicle. And largely the reason why ETFs are considered a tax-efficient vehicle is because of a point we made earlier—that most ETFs use an index strategy. And with an index strategy, you tend to see less change or turnover in the securities that represent that index. Certainly relative to, say, an active fund where the manager is looking at this stock versus that stock and saying, “Well, my thesis is broken down here. I’m going to sell that stock and buy this one.” So you tend to see lower turnover. And what that means is that the portfolio overall ends up selling fewer securities that have appreciated a lot and, therefore, create a capital gain. So that’s kind of at the core of ETFs as to why they’re tax-efficient. That same concept holds true for index mutual funds as well because, as we talked about, index mutual funds and ETFs are largely doing the same thing.

There is another dimension to ETFs that’s a little bit different, and that’s the process in which securities enter and exit that ETF. So in a conventional mutual fund, we send our dollars in, the portfolio manager takes those, invests them, and at some point, we extract those dollars, and the portfolio manager has to go out and sell those securities, and maybe some of those securities have appreciated in price, potentially creating a capital gain.

With an ETF, if there are more investors trying to leave that portfolio than enter it, the portfolio manager, to satisfy that need, will hand that basket of securities that represent the redemption request to a market maker, and that market maker will handle the selling of those securities to meet the investor’s need for the redemption. And so, the portfolio is never selling securities within its construct and, therefore, not generating capital gains that are passed along to the remaining investors. And so, that’s the additional part why ETFs can be a bit more tax-efficient than what you might see in a conventional mutual fund.

Talli Sperry: It sounds like a really nice feature to the product.

Rich Powers: It’s powerful, and I think often times what gets twisted a bit is that investors, or those in the news media, might go to the in-kind feature as the leading reason why an ETF is tax-efficient. Ninety percent of why it’s tax-efficient has to do with the strategy that’s chosen and because it’s indexing. That’s the leg up often times.

Talli Sperry: Okay, that’s good clarification. Thank you.

So we have another live question. So, Judy, thanks for asking, “For a market order of an ETF, is there a time of day that’s best to buy or sell an ETF in general?” This is a good one.

Josh Hirt: Yes. It’s a great question because we definitely have some general practices that we think are appropriate for trading. Most of them, Rich touched on. The only things I would add to that are specifically around time of day, really a key thing. If we take it back to where we were talking about, volatility and the uncertainty and what that has to do with cost, think about the morning of an open. You typically have price-setting behavior, not all participants are online, and it definitely takes some time. You see a volatility that is greater in the morning than you might throughout the rest of the day. Likewise, at the end of the day, to some degree but certainly, we would advise—let at least the first half-hour, hour of the market clear before transacting. It just allows for greater price transparency to really get the underlying value that’s not being caused by any volatility. So that would certainly be one piece that’s really key.

Along with timing, I think what I’ll also just mention a little bit, and we haven’t discussed international ETFs, but they do provide this other element of timing, which comes in as well, and within international markets you have the opportunity for an ETF to be trading here in the U.S. For instance, say, you’re trading a European equities ETF, there could be a time of day where the ETF is trading but those underlying securities aren’t actually trading in the local market.

Talli Sperry: Right.

Josh Hirt: Picture an event close to the end of a U.S. market day: European markets are closed, maybe some type of a geopolitical event, something that would move markets. ETF investors can take those views out and recognize what’s happening with the ETF immediately. Those underlying securities aren’t trading, so there is a larger disconnect. So, again, our advice would come back to: Find times when the local market and the ETF are both trading at the same time. We’ll just have a better experience for execution.

Rich Powers: Can I build on that? The idea of the market open there is really, really important. The ETF market price is derived from the value of the underlying securities that it holds. And so at the beginning of the market day, 9:30 [a.m.] or so, not every underlying security has been opened for trading. And so, as a consequence, market makers, the folks who are kind of pairing off Josh’s trade with Rich’s trade, are going to say, “I’m not sure what the price is of a handful of these securities, and so I’m going to make my spreads a little bit wider to cover me on that risk that I would be taking.” And so waiting till everything’s open and, by Josh’s point, 30 minutes in, you’re going to be pretty safe. You’ll get full price discovery in the market and, therefore, probably a better experience and a tighter spread than what you otherwise would receive.

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