With Vanguard recently launching their new bond ETFs, I can almost reconstruct my entire portfolio of Vanguard mutual funds using their equivalent ETFs instead. While they won’t work well for everyone, I am glad that Vanguard is offering this option to the public. Here are some index mutual funds and their ETF counterparts:

The ETFs certainly have an advantage in expense ratio if you don’t have the $50,000 needed to buy the Admiral shares of each fund. On average, the savings is 10 basis points, or 0.10%. That’s $10 a year on a $10,000 account, or $100 a year on a $100,000 account. In addition, the ETFs allow you to get around the minimum initial investments, as well as avoid the $10 per-fund low-balance fees, $10 per-fund IRA fees, and the purchase/redemption fees of many of their mutual funds.

In the disadvantage department are possible premium/discounts to NAV, the bid/ask spread, and commission costs. Vanguard even offers a cost-comparison calculator that takes many of these things into account.

The only ETF missing for me is their International Value fund, but I could replace that with the WisdomTree International SmallCap Dividend Fund (DLS).

Free Trades + ETFs = Cost-Saving Opportunity?
Right now, Zecco.com offers free trades with an account value of $2,500, while Wells Fargo offers free trades with an account value of $25,000. (Bank of America’s offering stinks, so I’m ignoring it.) Buying these ETFs with free trades would take away much of the traditional advantage of mutual funds.

Before I would switch to ETFs, my concerns include whether these brokers can sustain giving out free trades, and how good the customer service is. If they fail, would I keep paying slightly higher commissions on ETFs, or sell them all and go back to mutual funds? Something to ponder.

(You know what? I just figured out that Zecco stood for Zero Cost Commissions. No, I’m not the sharpest tool in the shed.)

Dividend Reinvestment Plans, or DRIPs, are programs that allow individuals to buy stock directly from the company, with dividends from the stock being automatically reinvested into more shares. Here are some popular companies that have DRIPs and also see the Wikipedia entry on DRIPS here.

DRIPs often charge no commissions, so if you set up a DRIP for General Electric (GE) and committed $50 per month, every penny of that would go towards buying $50 of GE, even if it meant buying a partial share. Dividends also get reinvested for free. The main startup costs involve buying one share through a broker and then transferring ownership to your name. This all made them a good alternative to using a broker and paying for every trade.

Do it yourself? Start with less than $100? No commissions? Sounds like something I’d go for. In fact, I don’t participate in any DRIPs. The main reason is that I’m really not interested in buying any individual company stock right now. DRIPS are meant as a very long term commitment, and I just don’t trust any one company to perform well for the next 30 years. On top of that, the accounting required to keep track of the cost-basis for all your shares sounds like a nightmare. Besides, I think there are better alternatives out there:

With just $50 a month, these days you can go through a company like T. Rowe Price or TIAA-CREF and invest in a low cost mutual fund that is diversified across hundreds of companies. It’s so easy a caveman could do it. 😉

If you have at least a few thousand dollars, there are now brokers that offer free trades like Zecco and Wells Fargo. I bet there will be even more to come in the future.

If you are waiting until the last second to fund your 2006 IRA, you’re probably not alone. Maybe you are still confused about choosing between a Roth or a Traditional IRA. Here’s an interesting fact: If you assume that your tax rates will be the same now as they are in retirement, the amount you end up with is the same whether you use a Traditional or Roth IRA. This is independent of time length and expected return

Let’s assume an annual investment rate of return of 8% for the next 30 years, and a marginal tax rate of 25% for all years. Let’s also say that you only have $1,500 of after-tax ($2,000 gross pre-tax) income to put away right now.

If you went with the Roth IRA, you pay your 25% tax on the $2,000 now ($500), but no taxes upon withdrawal:

If you went with the Traditional IRA, you don’t have to pay tax on the $2,000 right now, but you’ll be taxed upon withdrawal:

See how they are the same? The only difference is that you are able to put away “more” in a Roth IRA since the limits are $4,000 for either one. $4,000 post-tax in a Roth IRA is like putting away $5,333 in a Traditional IRA in this scenario. This ability to shield more money from taxes is why I chose to contribute to a Roth IRA. Now, if you change your assumptions about tax rates, that’s where you may start leaning more towards one or the other.

How good is the tax benefit?
Remember, either IRA saves you tax at least once. If you just kept it all in a regular taxable account, you would be subject to a tax on any dividends or realized capitals gains every year. Let’s see what happens to your $1,500 then. Taking the best case scenario of investing in stocks with only dividends being taxed and having no capital gains to deal with until you sell 30 years later, we’ll assume that the 8% annual return is broken down into 6% appreciation and 2% dividends. If the 2% in dividends are taxed at 15% each year, your after-tax return in 1.7%. If those dividends are reinvested:

At the end of 30 years, upon selling you’ll have a long-term capital gain of $13,885 – $1500 = $12,385. You pay tax of 15% on that: $1,858, leaving you with $13,885 – $1858, or $12,027.

With these simplified assumptions, using an IRA made you over 25% more money than if you didn’t use one. If you invested in any bonds, the difference would be even greater. 25% is huge! Imagine ending up with $500,000…. or $625,000. Which one would you rather have? This is why IRAs are a great opportunity to make your money go farther.

See here for some specific mutual fund ideas, part of my overall investing recommendations.

(This is not a comprehensive Roth vs. Traditional IRA post – There are just so many variables like the ability to take out principal without penalty, ability to use balances for a 1st home, required minimum distributions, and easy of inheritance to consider.)

Here’s another article by Jonathan Clements that I enjoyed – How Good People Make Bad Investments from the Wall Street Journal. It points that some traits that help us success in other parts of our lives actually hurt our investing performance.

For example, you would like to think the more energy you put into researching and trading stocks, the better your returns would be. But the research and historical data simply doesn’t support that. Here are some excerpts:

Athletes who train hard are more likely to win. Students who study conscientiously are more likely to get good grades. What about investors who diligently research their stocks? They’ll probably earn mediocre returns.

The fact is, the markets are full of savvy investors, all hunting for cheap stocks. Result: If there are any bargains to be had, they don’t stay that way for long. Indeed, much of the time, share prices are a pretty good reflection of currently available information.

“If you put in more effort, you’ll end up with worse results,” reckons Terry Burnham, co-author of “Mean Genes” and director of economics at Boston’s Acadian Asset Management. “It’s not the work. It’s the action that comes out of the work that’s the problem.”

Every time we buy a supposedly bargain-priced stock, we incur commissions and other trading costs. In addition, if we trade in our taxable account, we may trigger big tax bills, further denting our returns.

[…]

Your index funds will simply replicate the performance of the underlying markets, minus a small sum for fund expenses. Sound dull? You may be more excited when you look at your results — and you realize they’re so much better than those earned by optimistic, hard-working active investors.

In an interview on the website TheStreet.com, Jim Cramer of Mad Money fame talks about how he and other hedge fund managers can manipulate stock prices for easy profit. Check out the video, it’s very enlightening:

Although this actually aired online a few months ago, he’s now getting heat from various media sources that recently discovered it – including articles from USA Today and the New York Times, which provide a nice recap:

Cramer described how he would make bets that gave the impression knowledgeable investors were predicting a stock’s future. Cramer said everything he did was legal but added that illegal activity is common in the hedge fund industry, where regulation is lax.

Cramer said some hedge fund managers spread false rumors about a company to large trading desks and the media to drive a stock price lower. He said this practice is illegal, but easy to do “because the SEC doesn’t understand it.”

He also said Research In Motion and Apple are easy targets.

Mr. Cramer said he had used some of the tactics himself, including lying to ?bozo? reporters to get them to report misinformation on particular stocks. He singled out CNBC?s Bob Pisani. He separated legal activities from illegal ones (such as ?fomenting?), and never quite says he ever took part in the latter.

Let’s take a step back here. Cramer openly admits that he and others can manipulate the markets by spreading misinformation. And people actually watch his show for investing tips?!? Somebody’s getting rich, but it ain’t his viewers… Yet another reason not to trade stocks in the short term.

Do you see the data supporting index funds, yet still have the urge to try out some other theories? One way that financial folks try to resolve this conflict is with the concept of “Core and Explore” investing. I have no idea who came up with the name first, but essentially you split up your portfolio into two parts: a Core portion made up of low-cost index funds, and a Explore portion with which you can do whatever you want. This way, you can still watch CNBC, talk stocks around the water cooler, and try to decipher Cramer’s squealing. You get the rush of working to beat the market, but in the worst case you won’t fall too far behind.

Core Ideas (80-95% of total portfolio)
100% Target Retirement Fund, or
33% Total US Stock Market Index, 33% Total International Index, 33% Total Bond Index, or
Something based on one of these model asset allocation portfolios.

This part should be rebalanced regularly according to your pre-set asset allocation.

Explore Ideas (5-20% of total portfolio)
Individual Stocks
Actively Managed Mutual Funds
Options and Futures
Sector bets (Healthcare, Energy)
Currency Exchange, Gold, Commodities
Country bets (China, Russia, Japan, Brazil, India)
Market Timing (i.e. switching to 100% cash when bearish)

Many people mix index and non-index funds, but not necessarily consciously like this. I did have a “play money” account that I put a flat $5,000 towards before (as opposed to a percentage of my portfolio), but then I got busy/bored/disillusioned and liquidated it six months ago. I keep planning to revive it, but it just hasn’t made it up the priority list yet.