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Amy Chain: Hello, I’m Amy Chain, and welcome to tonight’s live webcast on ETFs. How do you determine if ETFs are right for your situation? Do you know the difference between an ETF and a mutual fund? Today we will talk about strategies for incorporating ETFs into your portfolio.

Joining us today to discuss this important topic are Rich Powers of Vanguard Portfolio Review Department and Brian McCarthy of Vanguard Investor Trading Services. Tonight they’ll discuss how to determine if ETFs should be a part of your portfolio. Welcome, Gentlemen.

Brian McCarthy: Thank you.

Rich Powers: Thanks, Amy.

Amy Chain: Now we’ll spend most of our evening answering questions from you, but there’s a few items I’d like to point out first. There’s a widget at the bottom of your screen, and that’s for accessing technical help. It’s the yellow widget on the left. And if you would like to read some of Vanguard’s thought leadership material that relates to tonight’s topic or view replays of past webcasts, you can click on the Resource List widget on the far right of the player.

All right, gentlemen, I think we should jump in.

Rich Powers: Let’s do it.

Brian McCarthy: Yes.

Amy Chain: Alright. First thing we’re going to do though is toss a question out to our audience. Audience, that question should be appearing on your screen now, and that question is are you currently invested in ETFs? Your options are yes, no, or no, but I’m considering it. So go ahead and respond now, and we’ll weigh in. We’ll talk about your answers in a few minutes. But in the meantime, Rich, let’s jump in with a question we got ahead of time.

Rich Powers: Great.

Amy Chain: And that question came from Jessica. Jessica says, “I’m starting at the beginning. Can you explain to me what ETFs are?”

Rich Powers: Okay, great question. Let’s unpack the acronym first. It’s really important. ETF stands for exchange-traded funds. Funds, it’s a mutual fund. ETFs are mutual funds. So pooled investment vehicles comprised of stocks or bonds, meant to be used to meet some type of investment objective.

Now most ETFs are index funds. That is a key differentiator relative to say mutual funds, which the majority of assets actually find their way into active strategies. One other thing as it relates to ETFs. Remember, ETFs, exchange-traded, that’s a key differentiator for these products relative to say a mutual fund. You buy this/sell this on the exchange.

Amy Chain: So they really could be called exchange-traded mutual funds?

Rich Powers: That’s correct.

Amy Chain: That’s great. Let’s see where our audience is. Looks like we have a mixed bag so far. We’ve got about a third and a third and a third. I would say that doesn’t surprise me. Does it surprise either of you?

Rich Powers: A little bit.

Amy Chain: A little bit? What were you expecting?

Rich Powers: Yes, I would say that I was expecting maybe fewer folks using ETFs today and perhaps a lot more folks contemplating using ETFs, just based upon what we know about investor behavior from industry studies, as well as just looking at our own client base.

Brian McCarthy: Yes, and considering a number that doesn’t surprise me, those that are interested, because we are getting more and more questions from our clients, and we hear more and more talk and visibility to ETFs just in the industry and with retail. But it does surprise me a little bit, even though we’ve had very favorable trends of ETF investing growing over the past few years. The third surprised me a little bit.

Amy Chain: Well then, I’ll say that you’re both probably right because if you take the “yes” group and the “no, but I’m thinking about it” group, you have two-thirds. So really it’s two-thirds of our audience is pretty close to thinking about ETFs.

Let’s toss another question out to our audience, and that question is what would you most like to learn about ETFs tonight? So go ahead and weigh in. Your options are how are they constructed, how to determine if they’re right for you, and how to invest in these ETFs? So if you weigh in, you can help inform where our conversation goes tonight. But while we wait for them to weigh in, I’m going to toss another question out to you guys. This question is, it builds upon the question that you just touched on, Rich: What are some of the advantages and disadvantages? What are some of the differences between ETFs and traditional shares of mutual funds? You want to kick us off?

Rich Powers: Yes, I’ll start with the differences. Maybe, Brian, you’ll take the advantages and disadvantages, but I think one of the key differences is that with an ETF, you can actually purchase that throughout the day. Alright, so you can buy it between 9:30 and 4 when the markets are open, and with a mutual fund, what you’re generally finding is that you purchase that at 4 p.m. when the market closes. And so that’s a key differentiator in terms of funds and ETFs. Otherwise, the governing structure, the regulatory structure that cuts across both ETFs and funds is largely the same.

The other point I’d make on ETFs and funds is that with ETFs you actually have the opportunity to buy as few as a single share of an ETF, where with most mutual funds they require some dollar investment minimum for you to meet. And so for an investor who’s maybe starting with fewer dollars to invest, an ETF might be a more accessible way to make an investment.

Brian McCarthy: Yes, thanks, Rich. I can just add on to the advantages/disadvantages, and I guess I would say two things that I would mention there. And I don’t know if it’s an advantage or disadvantage, more of a preference. So you may have some clients who value intra-day opportunities to invest in a mutual fund. And if that’s valuable to you, then an ETF may be the right vehicle for whatever your strategy may be.

But the other thing to really consider is costs. So if you are investing in an ETF, be it throughout the day, there’s transaction costs involved, and we may get to this in a bit. I won’t go too deep on it, but there’s transaction costs in the form of commissions that you may pay. And there’s also transaction costs in the form of what’s called a bid-ask spread. On a fund, there is no bid-ask spread because you’re trading at the end of the day. So depending on your time duration or how long you’re looking to hold that particular investment, you may weigh one more than the other.

Amy Chain: I’m glad you went there. The vast majority of our audience tonight is most interested in trying to determine whether or not ETFs are right for them. So let’s make sure that we’re spending some time trying to talk about why you might think about leaning toward an ETF or why you might be thinking about investing in a more traditional share as we go through our answers. How about that?

Brian McCarthy: I’ll just add one other component, and I don’t know if it’s necessarily— Rich, you were talking about how ETFs are made up mostly of index or passive investment strategies and mutual funds. For the most part, most of the assets are inactive, but certainly index or passive index, and passive is growing.

The key factor there is cost, and I think one of the benefits of ETFs, you have a lot of these index strategies, it’s a much lower cost. And, you know, we do know that keeping your costs low correlates very well to better investment return. So that is one of the advantages of an ETF, so really just an index strategy or passive strategy.

Amy Chain: Well, that’s an important point, I think, to hit on. Cost is always important. Is the decision whether or not an ETF is cheaper or whether or not indexing or a low-cost investing approach is the consideration?

Brian McCarthy: You know, my opinion, hey, it goes back to what we said earlier, your preferences. All things being equal, there’s a cost to operate the fund and that’s your operating costs. And that’s the expense ratio. If those are the same, it really comes down to what’s your preference? Do you value that intraday liquidity or do you feel more comfortable in the conventional mutual fund share class?

Rich Powers:And you could bring that back to the Vanguard ETF offer. Our ETFs and our Admiral™ Shares are actually very— are comparably priced. And so we’ve taken that decision off the table for investors in terms of saying ETFs or fund, more expensive, less expensive. They’re the same price. And then it comes back to well, what are you trying to accomplish? Is your investment horizon shorter or longer? Do you value flexibility in buying throughout the day? Do you have enough capital to meet some investment minimum to acquire those shares?

Those are kind of the key factors that’ll help an investor think about whether the ETF or say a conventional share class is right for them.

Amy Chain: Well, Bruce will be happy that you answered that way because Bruce just asked us if the expense ratios of ETFs are lower than that of index funds.

Rich Powers: Yes, so I would say what you find there is that if you look at ETFs and you look at index mutual funds, what you see is very comparable pricing. In the case of Vanguard, as I’ve just alluded to, identical pricing when you compare Admiral Shares and ETFs.

I think oftentimes where people look at the ETF as an advantage from a cost standpoint is they’re thinking about ETFs relative to the broad universe of mutual funds, which I think something like three-quarters of all mutual fund assets are in active strategies. Those active strategies have higher expense ratios. Therefore, the ETF generally wins out from an expense standpoint.

Amy Chain: Great; anything to add, Brian? I feel like I interrupted you.

Brian McCarthy: Well, I was just going to mention one of the strategies, one of the opportunities that customers leverage the ETF share class of Vanguard for, that’s specific to Vanguard, is when you mentioned the minimums. If they can’t meet a fund minimum, they can then invest in the ETF share class at Vanguard. So we do see customers leveraging for those purposes.

Amy Chain: Now Susan from Bend, Oregon, has asked us whether or not there’s any tax advantages to invest in ETFs. What do we have to say there? Rich Powers: Yes, so the narrative that’s out there around ETFs and their tax-advantaged nature, I think comes from two real key factors. One of them is very specific to ETFs, and one of them is a shared virtue with index mutual funds. So I’ll first tackle the one that’s sort of unique to ETFs.

With an exchange-traded fund, when an investor or series of investors accumulate enough shares that they want to kind of redeem from a mutual— from the ETF, rather than having the portfolio manager having to go and sell shares in all the companies that are in the portfolio, rather there’s an authorized participant that comes and takes those shares that want to be redeemed, turns them into Vanguard, and we hand them the underlying securities. And so that’s called an in-kind redemption.

Amy Chain: Now these are transactions that you’re talking about happening sort of on the back end of all this.

Rich Powers: Right. I mean any individual investors involved in this, but rather a bank or some other type of sophisticated institutional investor is kind of acting as an intermediary for all the investors who maybe want to redeem from our portfolio. And so when they get enough shares that need to be redeemed, they’ll come to Vanguard and say, “Please redeem us out X number of shares.” We will, in kind, turn those investors, the authorized participant, back shares in the underlying holdings of our portfolio. So we’re not going to the market and selling and, therefore, creating a capital gain. So that’s a virtue that’s very specific to ETFs.

What’s a shared virtue with mutual funds is that because ETFs are predominantly index funds, they have generally lower tax turnover, and so, therefore, you generally generate a lower tax bill. And so I think that’s why ETFs have this notion of being a little more tax-efficient. It’s accurate, but perhaps the reasons are less well known.

Amy Chain: So I think what I hear you saying is that ETFs, by the mere virtue of being an ETF, aren’t specifically more tax-efficient. It’s the portfolio management techniques that are inherent in managing an exchange-traded fund, an index fund that would contribute to the tax efficiency of these vehicles, relative to, say, an actively managed portfolio.

Rich Powers: Right, being an index fund allows for lower turnover. Therefore, you should expect probably a lower capital gains distribution, with respect to the other component being the in-kind redemption activity. Again, that’s very specific to the ETF construct.

Amy Chain: How about location of ETFs? Does it make more sense to put them in your tax-advantaged account or your taxable accounts? Should these be in retirement accounts or just savings vehicles?

Rich Powers: ETFs can work in an IRA, they can work in a regular taxable account. They play well with mutual funds, if you will. You can actually have a portfolio comprised of ETFs and mutual funds.

I think kind of taking it a step back and thinking about some of the best practices we offer to clients around asset location from a portfolio standpoint, because ETFs are comprised of index funds and index funds generally are a bit more tax-efficient, what you find is that you can hold those in a taxable account, and maybe your less tax-efficient portfolio, say an actively managed fund might belong more into say an IRA.

Amy Chain: So if there’s a particular investment that kicks off more taxable consequences, you might want to think about putting those in a tax-sheltered account, and a tax-efficient investment, one that isn’t going to trigger taxable events every year, should be in the account that you have to pay taxes on every year.

Rich Powers: That’s exactly right. Maybe the one other kind of asset class I’d point to would be say a taxable bond fund, right? That can come in the form of an ETF or a mutual fund. I think generally our counsel there is that you want to probably have that in a tax-deferred account because of the income that it’s regularly kicking off will be taxable every year.

Amy Chain: I think that also brings up another important point, which is the decision about whether to ETF or not ETF should come far after you’ve decided what your appropriate asset allocation should be. You should be deciding what you should be invested in before you’re deciding whether or not an ETF or a traditional share class is the right way to go. Is that—?

Brian McCarthy: That’s correct and I was actually— you mentioned corporate bond fund. I was actually thinking through, you know, if you have a municipal fund, regardless of whether it’s an ETF or the conventional share class, because of tax-free nature, you may want that in your taxable account. But it really— it’s both the ETF structure that may determine it but also the investment strategy.

Amy Chain: So you start with like, at the highest level, what’s my allocation between stocks and bonds? And if we’re talking about stocks, what types of stocks should I be exposed to? And then once you get down to the types of stocks you want to be exposed to, then decide the best vehicle with which to go obtain that.

Brian McCarthy: Absolutely, yes.

Amy Chain: We have a clarifying question coming in from Bob, Brian. I think it might be for something that you alluded to before, that’s this intraday timing, intraday pricing. Bob says, “So do ETFs essentially amount to trying to time the market as opposed to mutual funds?”

Brian McCarthy: Well, that’s a good one. Is that from Bob?

Amy Chain: That’s from Bob.

Brian McCarthy: Alright. No, hey, you know, I wouldn’t imply that ETFs are, in and of themselves, timing the market. So let me just make a distinction. ETFs are priced throughout the day. So an ETF, if you think of a conventional mutual fund share class, at the end of the day there’s a 4:00. We calculate the close, and that gets you the net asset value of the fund. That’s how we calculate it. That’s happening real-time throughout the day.

While it’s not a true NAV, we’re calculating what is the underlying portfolio worth, and that’s how you derive the price of the ETF. And that’s how it’s priced throughout the day. Now whether investors choose to be more active because they have the flexibility, that’s a different question. Certainly you would have the flexibility to be more active throughout the day, but that’s a little different.

Amy Chain: And I think some of the mechanics that Rich talked about are important to note as well. The mechanics of how an ETF is run makes it such that the negative effects to other shareholders of the fund that market timing could generate don’t. They’re not quite so susceptible when you’re talking about an ETF. Is that—?

Brian McCarthy: And we, well, yes, let me just go back and just clarify too. We did some research, and I think, Rich, you’re also familiar with this on the propensity of clients, at least at Vanguard, to transact. Are they more active in an ETF, and as a result, does it impact their investment returns?

And we saw very little difference in terms of clients had an investment objective. They had a time horizon; they were sticking to that time horizon. I think one quote that always stuck with me from Jack Bogle was, you know, time is your friend and impulse is your enemy, right? So if you have a certain objective or what have you, regardless of whether you’re in the fund or the ETF, you want to make sure that you can stay the course.

Rich Powers: Yes, the mere presence of that flexibility doesn’t necessarily set behavior. I can think of, my car says it can go a lot faster than I actually take it, and so there are other features around the ETF that make it attractive, one that may be flexibility. But by and large, to Brian’s point, we don’t see investors day-trading our ETFs. They tend to be long-term core allocations.

Amy Chain: Good, great. Thank you.

Okay, let’s take a question from Nora from Palm Springs. Nora, thank you for your question. Nora wants to, well, Nora suggests to us that she’s a pretty conservative investor. She wants to know if ETFs are inherently riskier than the traditional shares of mutual funds? Brian, you want to take that one for us?

Brian McCarthy: I’ll get us started, and then join in. So the ETF itself is a distribution model. It’s the wrapper. The real risk is in the portfolio strategy. So, and let me give you an example of what I mean by that. If you are in a portfolio that is very narrow, so let’s say I am in a sector-based portfolio invested in a narrow group of securities, those securities will generally be more volatile and, thus, the ETF will be more volatile and riskier than if I’m in a broad-based, balanced ETF with broad-based stocks. Right, so it’s more the investment strategy than I would say the ETF itself.

Amy Chain: Know what you’re buying and assess the risk of the investments, not the vehicle.

Brian McCarthy: I think that’s right, you know, and how does this particular investment fit into my portfolio, making sure that you understand the ETFs. You know, understand you can review the prospectus, review information on it, that it does match what your investment intent is. And then that’s really where the risk is derived.

Rich Powers: Right. I would say the other thing, maybe kind of spinning a little bit, not so much conservative per se, but I think buying an ETF does put a little more onus on the buyer of the ETF, right? The investor actually has to make some decisions along the way, so whether that’s choosing the order type or when they process their order, that all puts a little bit more responsibility for the investor. So if you’re not willing to make that kind of investment of time and energy to do it right, then perhaps for that person ETF isn’t the right vehicle.

Amy Chain: I think this is a great point to just sort of pause and say how should somebody get started? We know that our audience wants to know more, and we’ve gotten some questions tonight and ahead of tonight just saying, okay, so let’s assume I want to buy an ETF. Where do I go from there? How does somebody get started? Brian, why don’t you kick us off.

Brian McCarthy: So if you’re starting from scratch, you know, let me just assume you’re starting from scratch. If you’re starting from scratch, I think it comes down to those investment principles that are tried and true at Vanguard and any other investment advisors would say something similar where what is your investment objective? Like what are you trying to accomplish? What are your goals?

Based on that, what is your time horizon for those goals? What portfolio are we looking? What type of risk appetite do you have?

And then you’ll come to some type of allocation of what you want to be invested in. From there I think it really comes down to your preference and cost because, as we mentioned earlier, costs have the most— is the most correlated factor to positive investment return. The lower your costs in general, you would see better investment results. So I think at that point to get started on it, it’s going through, understanding how it fits in your portfolio, and then understanding things like the expense ratio of the fund, the commissions, and what Rich just mentioned, do you feel comfortable, because it is a little bit more hands-on with an ETF investment than it would be in a fund.

Amy Chain: Why don’t we just pause for a minute and talk about what some of those considerations would be that make purchasing an ETF a different experience for the investor than purchasing a mutual fund. You alluded to some commissions. There’s some other considerations that you’d have to think about. Can one of you tackle that for me?

Brian McCarthy: I mean, do you want to start? Do you want me?

Rich Powers: Sure, sure, I think commissions is a key one, right. Is there a cost to actually purchasing the ETF or selling it, I guess, after you’ve purchased it. I think understanding the investment strategy of the ETF is a really important one. Right, I mean that, perhaps, is one of the most important drivers. So before you even make the ETF decision, is the strategy one that you would be comfortable with?

Order type is, I think, really important. What type of order are you going to utilize to execute your trade? Is it a market order? Is it a limit order? At what level do you set the limit order? All those are, I think, really important.

Amy Chain: And those determine the price that you may get on the share that you’re purchasing, whether it’s a stock or an ETF or anything. I think for some novice brokerage investors, this is all new, new terminology for them. So anything that we can do to explain what some of these words mean, I think, would be helpful for our audience to understand.

We have a live question that’s asking about the dividend and capital gain treatment. Are dividends and capital gains treated differently in ETFs than they are in mutual funds?

Rich Powers: So I’ll take that. So dividends are actually treated the same way. Coming back to this concept of ETFs and mutual funds are basically the same structure, just with the difference in terms of how they’re purchased or what venue they trade on. So dividends are treated in an identical matter because ETFs are thought— The same thing with capital gains. If you receive a capital gain from an ETF or a mutual fund, they’re taxed in a comparable manner.

Now I think what’s different is that because ETFs are largely index funds, what you generally see is that there are fewer capital gains paid out relative to say your average mutual fund because they tend to be higher-turnover portfolios. That might be where you see a distinction, but it has nothing to do with their taxation from an IRS perspective.

Amy Chain: I’m sensing a trend here. Anything to add?

Brian McCarthy: No.

Amy Chain: No, okay, great. Speaking of terminology, we’re getting a lot of questions here tonight about bid-ask spread. The bid-ask spread is something we heard a lot about ahead of this evening’s event. So we asked Jessica, a senior trader in Vanguard’s Investing Trading Services Group, to talk to us about bid-ask spread. Jessica?

Jessica Clancy: Thanks, Amy, I’m happy to. The bid is simply the highest price that buyers are willing to pay for shares of that ETF at a given time. The ask, on the other hand, which is sometimes called the offer, is then the lowest price that sellers are willing to sell those same shares at. The spread is simply the difference between those two numbers. So if you have an ETF that is bidding $110.50 and asking $110.55, then the spread would simply be 5 cents.

Amy Chain: Thank you, Jessica. Now why is that important?

Jessica Clancy: Yes, the spread is important to know because it can give you an indication of what your total trade costs are going to be. Additionally, it can give you an insight into how liquid or illiquid an ETF is, meaning how easy it is to buy or sell that ETF. So an ETF with an a narrower spread or a smaller spread like a penny, for example, would be a pretty liquid ETF and probably easy to buy and sell. But an ETF with a wider spread, 5 cents, 10 cents, that gives you an indication that it’s a bit illiquid and maybe could be more difficult to buy and sell.

Amy Chain: Alright, Jessica, thank you. Brian, let’s pick up where Jessica left off. Let’s talk about liquidity.

Brian McCarthy: So liquidity, you know, it’s important to understand how the pricing is determined, first and foremost. So to say something’s liquid or illiquid, it might be liquid or less liquid. But if you have an ETF as an example that’s made up of large-cap securities that trade very actively throughout the day and have, as Jessica described the bid-ask spread, a narrow bid-ask spread, that’s how the price of the ETF is derived. So, generally, you’ll see a correlation where the portfolio, if it trades with a narrow spread, the ETF will trade with a narrow spread. If there’s a lot of shares available in the underlying securities making up that fund, then the ETF may have more available in the market.

So the contrary would be, a contrary example would be if you have a high-yield corporate bond fund—generally spreads on high-yield corporate bonds are a little bit wider, a little bit harder to invest in some of those securities—and, therefore, you would find a high-yield corporate bond fund ETF may have a wider spread than say a large-cap equity security.

Amy Chain: But compared to another high-yield corporate bond fund ETF, the spreads might be comparable?

Brian McCarthy: They might be comparable, and I know Rich and I have talked about this before. All things being equal, if you had two high-yield corporate bond ETFs, that’s where you would want to say if one had a narrower spread, my implementation costs are lower, and, therefore, I may lean towards that issuer’s ETF versus another issuer’s ETF.

Amy Chain: And information about the bid-ask spread is available when you’re looking at information about ETFs.

Brian McCarthy: Absolutely. You know, all the financial service firms or what have you when you’re looking to invest, you can get that information.

Amy Chain: Now we talked about liquidity. Jessica mentioned it, you mentioned it. Let’s pause for a minute and define what liquidity means for our audience.

Brian McCarthy: Liquidity is, Jessica talked about how the bid is somebody willing to buy and the offer or ask is someone willing to sell. And I would just think of it as someone’s willing to buy or sell a certain number of shares, that’s how many shares they have available. There’s other market participants that may be willing to take risk, so there’s a certain amount of shares that they’re willing to buy or sell at the price that’s indicated.

Liquidity would be the number of shares that are available, and when you invest, you would want to make sure that the number of shares you’re trying to purchase are available at that price. And that’s also, you asked about can customers find that information. You will see that information represented.

Amy Chain: Anything to add?

Rich Powers: I think Brian covered it there. I think liquidity is a common piece of conversation that we have with investors. Where it’s perhaps most important is for the institutional investors who are transacting very large blocks who may want to trade at levels that are greater than the liquidity that’s available on the website or on some other type of application.

In general, you know, for the investors we’re talking to here today, I’d say what they would find is that they would generally be for kind of broad-based portfolios, ample liquidity at the levels they want to transact at.

Amy Chain: Large, sort of easily accessible, popular ETFs wouldn’t be faced with the same liquidity concerns than say smaller, more, say, thinly traded. Is that a reasonable—?

Rich Powers: Yes, that’s right. And Brian talked about this more, a broad index fund that covers U.S. stocks, international stocks, or a large segment of those universes is going to probably have a high level of liquidity.

As you get narrower and narrower, that’s when you may see less liquidity, and, therefore, it’s just a really important data point to have at your fingertips.

Amy Chain: We’re getting questions more about those, the buy, sell, and order limit terms that we threw around earlier. Brian, can you pause to define some of those for us.

Brian McCarthy: So buy/sell limit, there’s a few different order types, but I guess I’ll just start with the limits since that’s a question. So a buy/sell, a buy limit or a sell limit is when the customer or the investor has taken complete control of the price that they’re willing to achieve in the market. So you’re guaranteed that that’s a price you’re going to receive if someone’s—

Amy Chain: I’m willing to pay $1, and I will only pay $1.

Brian McCarthy: Right, but then you have to make sure that someone’s willing to sell at $1. So you’re guaranteed the price, but you’re just not guaranteed of an execution.

The other type of order that’s frequently contrasted with limit orders are market orders. So in a market order, if you see a quote in the marketplace and you say, “I want to buy it at market,” similar to going to a marketplace, right, you’re buying it, that current price as it is available in the marketplace.

Amy Chain: Like when you want to get lobster at a restaurant, and it says “MP,” and you don’t know what you’re going to pay, but you’re willing to pay it if you want that lobster. Is that a fair analogy?

Brian McCarthy: I don’t eat lobster, but, yes, I’ve seen people do that. So I would say that’s a very fair analogy, yes.

Amy Chain: I just threw myself off with that.

Brian McCarthy: Well, I didn’t bring up the lobster; you brought up the lobster, Amy. You must be hungry.

Amy Chain: Yes, I must be hungry.

Amy Chain: How about from a timing perspective? We talked about how these vehicles trade intraday. Is there a better time to think about making a transaction using an ETF? In the morning, closer to the close of the day, or do you need a crystal ball for that?

Brian McCarthy: Well, you need a crystal ball if you want to buy at the low of the day, right? So that would be a great order type. I wish we had it. I like to buy at the low today, but what I would say is I’ll get to, and, Rich, certainly jump in, but the most important thing to pricing an ETF is pricing transparency of the underlying security. So as we talked about earlier, at the end of the day for your conventional mutual fund share classes, the security is closed, your priced security for the fund is priced. For ETFs, securities are trading throughout the day, so the ETF is being priced in real time. So that pricing transparency is really, really important.

And so throughout the day, I would say, as an example of pricing transparency, if you were investing in a U.K., an international equity fund, well, in the middle of the day, on New York Stock Exchange time, the U.K. market closes. And, therefore, there’s a little less transparency in the second half of the day. So depending on what investment you’re looking to put your investment in, it may influence what time of the day you want to invest.

Rich Powers: I tell you one thing I would add to that is just being mindful, actually you alluded to this, Amy, at the beginning of the day and the end of the day. So generally speaking what you find is there’s a little less activity, fewer market participants at the beginning of the day or the end of the day. And so as a consequence you might see a little more volatility around the market price of the ETF relative to its underlying value.

And so what we generally counsel investors is if you can, maybe avoid that first 15 to 30 minutes of the market time and then maybe at the end of the day that last 15 minutes because there may be anomalous things happening there as market makers and other participants kind of step back and close out their books.

Amy Chain: You talked a little bit about transparency and you talked about making sure the price relative to the underlying security— How can people tell? Where should they go to look to see if this ETF that they’re thinking about purchasing is providing price transparency?

Brian McCarthy: You know, Amy, I think there is information available. It’s generally updated every 15 seconds throughout the day. But for the most part, I think the rule of thumb is probably a better guide for investors. And I would just build a little bit on Rich’s point about the open and the close. So at the open, if you think about it, on any given day, on a stable day, generally the ETF would be priced in parity with the underlying securities pretty quickly after the open. But you may have an event such as earlier in June, we had the Brexit event, if you place a transaction on Thursday night and the Brexit vote comes out, what that ETF and the securities may open up at could be very different than where it closed.

So if you have some uncertainty for the next day, that’s where you may want to leverage, even if you wanted to trade it there, and control the price that you’re looking to achieve with a limit order. So that’s another opportunity to leverage that.

Amy Chain: Very good. Now Gilberto asks a question that I think, Rich, probably goes back to the conversation you were having about the in-kind transactions that happen in the portfolio. Gilberto asks, “If you sell an ETF, do you sell it to another investor or back into the fund?”

Rich Powers: So, when you sell an ETF, you’re generally actually transacting with another investor on the exchange, right? So we talk about primary trading and secondary trading within ETFs. So primary trading is when an authorized participant, as I talked about before, comes to Vanguard, says, “Here’s a basket of securities.” Vanguard returns to them shares of our portfolio that they go and sell to their clients. Secondary trading is when investors transact the exchange across themselves, and that’s actually where you find most of the trading activity in the marketplace. I think the stat that I’ve seen is something in the order of 85% of all trading ETFs happens in the secondary market. So Rich Powers, wanting to exit his large-cap equity ETF, Amy Chain wanting to buy that, we face off, find a price that both of us are comfortable with, and that’s how it works.

Amy Chain: Very good. Humberto asks about his portfolio, which is made up solely of ETFs; he wonders if there’s any additional risk on this model against using traditional mutual funds.

Rich Powers: Yes, I think, for those investors who build an ETF-only portfolio, I don’t think that you would classify that as having any more risk than a mutual fund-only portfolio. I think the risk is are those the right products that help you reach your investment objective? If you’re really kind of a risk-averse investor and you’re looking for income, and your portfolio is comprised of emerging-market ETFs or very narrow-sector ETFs, then I think that’s the risk. The same thing would be said on the mutual fund side.

So I wouldn’t say having an all-mutual fund or an all-ETF portfolio is any riskier than the other. Having a mixed portfolio isn’t any riskier than the opposite ends of those spectrums.

Amy Chain: Particularly for a long-term buy and hold investor. As we talked about, first you decide what your right allocation is, you decide how you’re going to accomplish that allocation, you decide what vehicle you want to purchase to accomplish that allocation, and then you say, “Can I do it more cheaply with a traditional share class or an ETF share class?” And once you’ve made the purchase, there’s little difference in your experience between the traditional share or an ETF. Is that right?

Rich Powers: That’s exactly right.

Brian McCarthy: Yes, I think the impact or risk you could have with an ETF portfolio, if you did not stick to a particular plan or investment time frame and you were a little bit more active and paying some type of commission for those investments, that could certainly eat into your longer-term returns. So that would be more of an impact for the more active clients.

Amy Chain: Robert from Kentucky has asked us to alleviate some of his anxiety. Gentlemen, this is a tall order.

Rich Powers: I’ll try.

Amy Chain: Not a tough question, but a tall order. Robert asks if, he says that he’s concerned about buying investments at greater than their investment value when they can later sell at less than their investment value. He has trouble buying ETFs because they’re not marked to market. So first let’s pause and talk about what marked to market means, and then let’s alleviate this anxiety that poor Robert is facing. Rich, you want to take that?

Rich Powers: Sure, so marked to market means that the value of the securities is struck at the current time, it’s current day, rather than being stale, say a day or two or three days old. And so that’s effectively what marked to market is. And in the case of ETFs, they absolutely provide marked-to-market exposure. It’s one of the vehicles that actually provides you the greatest insight from a minute-to-minute perspective as to the value of the underlying securities it’s represented by.

Amy Chain: So though it’s different from potentially the opening or the closing price of the fund, it actually represents the true marked-to-market value of that investment throughout the day.

Rich Powers: Right. If you demanded liquidity at any point in the day between 9:30 and 4, the ETF would provide you that, and it would provide a perfect transparency or insight into what the market ascribes a value to those securities in there for that ETF.

Brian McCarthy: I may be a little too inside baseball, but I’ll just add we talked about how when you’re trading on the exchanges and the secondary market, you’re trading with other investors. You’re trading with other investors, but it may not be retail investors. So there’s more participants called market makers. They’re also the authorized participants who are able to exchange and redeem shares with issuers such as Vanguard. But what they’re doing throughout the day is they’re pricing their models to say, “What is the underlying securities priced at?” And they’re making a market in the ETF. So that’s why you continue to see a spread that Jess mentioned get tighter and tighter, and we have teams similar to other issuers at Vanguard, Capital Markets team, that is actively working with those market participants. Very diligent about helping them understand how to price our portfolio so those ETFs can get there and, obviously, better returns for investors.

Amy Chain: Now how can an investor tell if they’re getting the right price for that portfolio?

Brian McCarthy: There is, Rich, feel free to jump in here. There is intraday pricing available that they can look up, but then it’s delayed. It’s only updated every 15 seconds, so the way the market moves, it moves pretty rapidly. You know, what I would share is, it’s really important that you feel comfortable with the firm that you’re investing through. So as an example, and I have peers at other firms that work very hard at this, investment professionals that have best execution obligations. And what we do is we transact with different market participants, and we measure the amount of a liquidity—we talked about earlier—how much liquidity can you give our client? How many shares can you price improve.

So Jessica talked about the bid-ask spread, a vast majority of transactions that occur through some of these firms actually get what’s called price improved. So you get even a better price than what you saw in the quote. So I think it’s really important if you’re looking to get a good price that you feel comfortable with the firm that you’re trading through.

Amy Chain: Very good. Now you touched on bid-ask spread again, and Layla’s asking us a clarifying question. She wants to know again where she can find the information about a bid-ask spread on an ETF at any given moment.

Brian McCarthy: So there’s quoting information pretty much on all the financial sites, and what you’ll see on there is you will see something that says, “Here’s the bid,” and then you’ll see the price and you’ll see the ask. And then you’ll also see what’s called the size, and they’ll usually have, let’s say, for example, they said it had 5×10. What that represents is 500 shares by 1,000. So that would mean the bid price is $50 for 500 shares, and the ask price is $50.10 for 10, which would be 1,000 shares.

Amy Chain: So if you went to vanguard.com, you could just punch in the ticker for an ETF, and all of this information would come up for you.

Brian McCarthy: Absolutely, on the quote screen. Yes, absolutely.

Amy Chain: And you could search for any ETF on Vanguard’s website?

Brian McCarthy: Absolutely, yes.

Amy Chain: Good, great. We have another live question. They just keep coming in. Keith is asking about the considerations for short- and long-term investments. Please explain. If I’m thinking about five to seven years, is that short- or long-term? I think this is an important question. This is sort of bigger than just ETFs or not ETFs, so let’s level-set on time horizon.

Rich Powers: Right, so I think short and long is in the eye of the beholder, right? But I would generally say that five to seven years would constitute a long-term time horizon. And so whether that directs you to the mutual fund or ETF, I think it’s largely around your level of comfort and the strategy that you’re trying to execute on, the cost, and the amount of money that you want to invest.

And so I would say five to seven years feels like a long-term strategy to me. If we’re talking about an investment horizon that is say a year or less, that feels pretty short-term to me. And so I think those would be kind of general definitions that I would think about.

Amy Chain: The bigger question is how comfortable would I be with volatility in my portfolio over five to seven years, not so much should I be in an ETF or a mutual fund.

Brian McCarthy: That’s right.

Rich Powers: That’s exactly right.

Amy Chain: Okay, we’ve talked about liquidity. We have a few more questions about that. Let’s pause again and, say, talk about whether or not being liquid or not, or relatively liquid, makes it harder to sell an ETF.

Rich Powers: I think a less-liquid ETF, again, it’s kind of all relative, but an ETF that’s less liquid, it may be a little bit more difficult to sell that, all things considered. So, therefore, there might be a little bit more give you have to make in terms of the price you’re willing to take. If you absolutely demand liquidity and need to be out of that security, for whatever reason, right? There’s some emergency arose in your life. Even though you had the best of intentions and you wanted to hold this forever, but something happened and you needed to tap into that fund. Well, that might necessitate you saying, “You know what, the liquidity is really, really important to me, and the access to my capital is really important to me, and so I’m willing to give up on the price that I take just to get access to the capital that I need.”

Amy Chain: Now Bernadine is asking us about how she can invest in ETFs at Vanguard. Brian, can you talk to us about that?

Brian McCarthy: Well, you know, I can, and similar to many other firms, to invest in an ETF, you would have to open a brokerage account. So that is the platform that affords you the flexibility to invest in many different products, be it a broad array of mutual funds. Some financial firms offer fund supermarkets. There might be fixed income products, equities, but also as a question, as ETFs. So because it’s specific to Vanguard, I don’t like to do a sales pitch here, but I’ll just explain for Vanguard you would need to open a brokerage account, you would fund the account, and then at that point some of the things we talked about, it would determine what portfolio you’re looking for. You could derive the ETFs that you’re interested in investing in. And as you just mentioned, Amy, we don’t just offer Vanguard ETFs here, right? We offer Vanguard ETFs and really all exchange-listed ETFs from all the issuers.

One of the benefits you get at Vanguard, if you’re interested in investing in a Vanguard ETF, is we talked about cost being such an important factor to investment returns, the 70 or so ETFs that we offer are zero-commission on our platform. So you may not find that if you were at another financial firm, although other financial firms do also have zero-commission ETF offers out there. But I would say even if you’re paying a zero commission, always be mindful of the operating costs of that particular investment because there may be the case that there’s a high expense ratio, and you’re paying zero commission where you’d rather pay a seven- or ten-dollar commission for a lower-expense ratio option.

Rich Powers: Yes, I think it’s really important, so cost is so key. I know we talk about that a lot at Vanguard, but there’s really three big components to cost when you’re thinking about an ETF. It’s the expense ratio, it’s the commission you might pay to transact, and it’s the bid-ask spread. When you kind of looked at them all together, side by side, and do a comparison, that’ll give you a sense for what is it going to run me to hold this portfolio for a year, three years, five years, and then you can make an informed decision.

Amy Chain: And, importantly, if you’d like to know more about ETFs, you can click on the Resource widget on the bottom of your screen, and it’ll take you to a wealth of information on the topic.

Let’s talk about the role of ETFs in a retirement portfolio. Rich, can you take that one for us?

Rich Powers: Sure. So I’ll first start with the place where you don’t actually find many ETFs, and that’s in a retirement portfolio in say a 401(k) plan or a 403(b) plan. What you generally find there is mutual funds, and the reason why you wouldn’t necessarily find ETFs in those particular structures is that they’re already tax-advantaged accounts, and one of the key kind of advantages of an ETF is that they’re low-turnover, lower capital gains bill.

Also, the reason why you wouldn’t do that is because when you’re purchasing into a 401(k) plan, you’re usually making biweekly or monthly contributions, and so the commissions you might encounter to buy those ETFs in a 401(k) might erode any cost savings that come from a lower expense ratio.

But where you will find ETFs held, and we see that in our own data in our own clients, is in IRAs. And so ETFs can fill a role in an IRA in the same way a mutual fund can. And so, again, I keep coming back to this, but it depends upon what strategy, what structure best fits your needs. And they both fit mutual funds and ETFs in a taxable account in an IRA.

Amy Chain: I think that gets a little bit at Stu from New Jersey’s question too. Stu says, “I’m not a frequent trader. Are ETFs for me?” I think you can probably take us through that again. Why would a buy-and-hold investor want to consider an ETF?

Rich Powers: Yes, so I think, right, you don’t have to trade. You can if you’d like, but generally we know that maybe it’s not in the best interest to trade frequently. But the flexibility exists.

So why would you buy an ETF if you’re a long-term investor? You don’t have enough money to make the minimum that’s required for a mutual fund; that will be one reason. The ETF may provide a lower expense ratio than the alternative mutual fund that you’re looking for.

The flexibility piece that we talked about before, throw that out. It doesn’t have any value to you. But I think those are the key reasons why you might consider doing it, from an investment standpoint.

Brian McCarthy: I just would add one other factor. At Vanguard you talked about how the ETF is another share class of our funds. That’s not necessarily the case with all issuers. So many of the products that you see being put to market only have an ETF share class, especially some of the more narrow sector-based. So if you were interested in a niche product or there’s a lot of commodity or what have you, ETFs and ETNs that are out there, that may be the only option available to you; so that could also drive some interest in ETF.

Rich Powers: So you mentioned commodities. It brought me back to one of the questions I was asked earlier, which is, is there a different tax treatment for ETFs and funds? And I’d say one thing. I’ll disqualify my prior answer and say commodity ETFs can be and are treated differently from a tax standpoint.

And so I’d say that would be kind of the unique situation where there’s a different treatment.

Amy Chain: Tell me what you mean by that.

Rich Powers: So that there’s a different taxation of commodity portfolios. Commodity portfolios would be comprised of, say, oil, gold, silver. The IRS has different rules as to the tax rate you pay on the income that’s generated from those portfolios.

Amy Chain: And that’s more due to the underlying securities held within the ETF, not the mere fact that it’s an ETF?

Rich Powers: Right, well, there’s that. But then it’s also, within ETFs, there’s a couple different structures. There’s the structure that has the same governance as mutual funds, and some of these “niche-ier” products have a different structure. They’re regulated by a different investment company act, and so the IRS treats them differently from a tax standpoint.

Amy Chain: Know what you’re buying. You have to know what you’re buying.

Rich Powers: That’s correct.

Brian McCarthy: I was going to mention you asked earlier what are the risks of ETFs, and we talked about really understanding how it fits in your portfolio. But it’s really also understand what you’re buying because what Rich is referring to, a lot of people put every, all these investments under the ETF umbrella. They’re really under the, I’ll use another acronym, ETP or exchange-traded product umbrella of which ETF is one. But some of the examples are exchange-traded notes. ETNs, which a lot of those investments are. And it’s a dead instrument. It has a different taxation and different risk. You’re taking the risk of the person that’s issuing that you don’t have within ETFs. It’s probably a little more complex to get into now, but really make sure you understand what you’re buying.

Amy Chain: Most important thing, know what you’re buying.

Brian McCarthy: Know what you’re buying, absolutely.

Amy Chain: How does one evaluate the performance of an ETF? Yes, Warren would like to know.

Rich Powers: Yes, well the place that I would start is generally you’re finding that these ETFs are index funds. The index funds’ objective is to try to deliver to you the returns of a particular segment of the market, as close to their benchmark as possible. So a really quick and simple way to evaluate that would be look at the return of the ETF relative to the benchmark it’s tracking. If that portfolio is delivering returns that are within the expense ratio of the benchmark, pardon me, the expense ratio of the portfolio, then that’ll tell you that the portfolio manager who’s running that portfolio is doing a really good job. They’re delivering to you what you’re hoping for, which is a return of a particular segment of the market. So I think that would be, really, the key parameter for most investors to start and really begin with, end with.

Amy Chain: Now does that change at all, depending on what type of investment class we’re talking about, so does how close to an index something is matter if you’re talking about like large-cap stock funds versus bond funds? Are there different considerations?

Rich Powers: Go ahead, Brian.

Brian McCarthy: I was just going to say, if it’s an index fund in general, you’re going to have, again, in general, lower cost and generally more predictable returns tracking towards an index. If you move into an active fund, which may be beneficial, right, it’s a little bit more predictable relative to the returns of the market, active is where you have portfolio managers who are seeking to differentiate the returns versus the market, what’s called alpha, and they’re trying to create differentiated returns. But with that you may get more volatile returns. So you could underperform or outperform the market at any given point in time.

Amy Chain: And that’s an index versus active managed—

Brian McCarthy: Yes, it goes back to the whole passive versus active, as opposed to conventional mutual fund share class versus an ETF. But I think Rich is absolutely right. Certainly if you invest in an index product that’s tracking an index and it’s passive, it sounds maybe, I don’t know if it sounds digestible or what have you, but you certainly wouldn’t want to outperform the market significantly because that would really mean that you could underperform the market at any given time. So you’d really want to measure based on tracking.

Rich Powers: That’s risk, right? So, right, when you’re outperforming by a meaningful amount relative to what you thought you would, we know that it can cut both ways. And that’s not what you signed up for. You said, “Listen, I’m not interested in outperforming the market. I’m interested in getting the market’s return.” And if your firm can deliver that as close to the benchmark after accounting for expenses, you should be a happy investor.

Amy Chain: And we’ve got a couple of questions coming about the mechanics of a brokerage account. Brian, I’ll let you kick this one off since you started us down this path a few moments ago. John is asking how to use a brokerage account to buy and sell ETFs.

Brian McCarthy: So I would just look at the brokerage account as a platform that affords you flexibility to do many things. So I’ll give examples that we see frequently here at Vanguard. What we find is clients are trying to simplify their investment portfolio when they’re managing their portfolio. So they’ll consolidate their assets with a firm, such as Vanguard or one of our competitors, and they’ll be able to consolidate all their assets, whether it be funds from many different issuers—Vanguard and the likes. There may be equities. It may be some CDs. It could be fixed income securities. It could be ETFs.

So people use it to consolidate, simplify their reporting, one view of their total portfolio. Once you have that open though, in addition to consolidating, you have the ability to invest in whichever products that are available in the marketplace.

Amy Chain: The brokerage account is sort of the doorway into your investments.

Brian McCarthy: That’s right.

Amy Chain: You can invest in anything once you’re through that doorway.

Brian McCarthy: Correct.

Amy Chain: And another question. Rich, maybe you can start us on this one. Dennis asks if you sell an ETF, can you sell specific shares? In a mutual fund, you’re selling at average cost. Is that correct?

Rich Powers: Right, so I think in the case of an ETF and, Brian, keep me honest here, you can do specific identification, right? So you can say, “Well, I bought a lot of shares on this ETF, 100 shares at $50 and shares at $75, and the current market price is at $80 for that portfolio.” And so I can say, “You know what, I’m going to sell that lot that I bought at 50, take that loss, and use that to offset other gains.” And so that’s available.

Amy Chain: And there you’re talking about the price of the ETF that you purchased, not the prices of the underlying securities within that, correct?

Rich Powers: That’s exactly right, right.

Brian McCarthy: Yes, no, that’s 100% right. We offer clients the ability, as do many other firms, to specifically identify or you can go on a FIFO basis or what have you, whatever you elect at the time of your transaction, you have that opportunity.

Amy Chain: How about dividends? Peter from Ohio is asking whether or not there are ETFs that specifically focus on dividends.

Brian McCarthy: There are certainly ETFs that invest in high-dividend securities, and, you know, you also have the opportunity if you purchase some of those ETFs on a brokerage platform that many of our clients choose to actually reinvest those dividends right back into the portfolio. So, yes.

Rich Powers: It’s been a popular product concept, for us as an organization, but also broadly in the industry. We’ve seen investors embrace more and more equity, whether mutual funds or ETFs, that are focused on either high dividends or growing dividends.

Which brings me to a point we’ve talked about a lot, which is know what the strategy is that you’re purchasing, right? There’s a subset of portfolios that say I want to maximize the income that I get by buying stocks, and so you might end up with a very concentrated sector bet in a portfolio. Maybe your high-dividend product is really focused on utilities and telecom; perfectly fine investments, just know what you’re getting.

The dividend-growing concept, right, so you want to buy companies that have a history of growing their dividend. That might tell you something about the underlying management’s approach to managing those businesses, a great strategy. But if your intention is to get a high income stream from that portfolio, then perhaps that’s misaligned. That’s maybe not the right product for you and the objectives that you have.

Amy Chain: Yes, that lends itself well to a question from Mark from Michigan who asks whether or not there are particular asset classes that lend themselves well to being offered up in an ETF format?

Rich Powers: So there’s 2,000 ETFs in the U.S. here today. They cover a range of categories. It’s broad U.S. stock indexes, style indexes, small-cap value. There’s international equity indexes, and you can cut that finer to say developed markets or Europe or emerging markets. And then we can go niche-ier, niche-ier. You can have products focused on a particular sector within a given country. So there might be too much availability of different strategies because an open question is the utility of niche-ier, niche-ier products for an overall investor portfolio.

So I think nearly any investment concept you can think of, there probably is an ETF for that. Whether that’s an investment strategy that’s actually right for an investor, I think that’s a whole ‘nother matter.

Amy Chain: Alright.

Brian McCarthy: I think we’re even seeing a lot of growth in the active space, so some of the active strategies are starting to get in and issue more and more ETFs. And I think it’s all about the distribution. So you think about listing an ETF, an exchange-traded fund, on an exchange, you immediately open up the opportunity for all the investors who have brokerage accounts, like we talked about, to invest in that ETF. So it’s somewhat of an efficient distribution approach which helps some of those issuers keep costs low, which we’re certainly all for.

Amy Chain: Well, that sounds like a good place to wrap up our conversation. Brian, I’ll start with you. Any final thoughts for our viewers before we close this evening?

Brian McCarthy: You know, I would probably just say ETF, conventional mutual fund share class, I would really start with what’s your investment objective? What’s your risk tolerance? What’s your time horizon? And then determine where your preference lies. But come up with a plan and stick to the plan.

Rich Powers: And if you’ve chosen an ETF, cost is so, so important. I’ll just go back to those three areas I touched on earlier. Know what the commission is that you’re paying, know what the expense ratio of the portfolio is, know what the spread is. If you have a good handle on that, I think you’ll be able to make a better decision as to what ETF might be right for you.

Amy Chain: And I’m going to add one more to that. Know what you’re buying before you buy it.

Brian McCarthy: Know what you’re buying.

Rich Powers: That’s right.

Amy Chain: Good, well thank you and thank you all for watching. In a few weeks we’ll send you an email with a link to view highlights of today’s webcast, along with a transcript for your convenience.

And if we could have just a few more seconds of your time, please select the red Survey widget. It’s the second one from the right at the bottom of your screen, and respond to a quick survey.

We really appreciate your feedback, and we welcome any suggestions you have about topics you’d like to hear us cover in the future.

And I’m hoping that you’ll join me at our next webcast on “Achieving Your Ideal Retirement.” Just click on the green Resource widget and use the webcast registration link to sign up, and I will see you then.

From all of us here at Vanguard, we’d like to thank you for joining us, and we’ll see you next time.



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