ETF’s vs. index funds: fight!

Though the financial media buzz has faded somewhat in recent years, ETF’s (exchange-traded funds) exploded in popularity in the mid-2000’s as an alternative to index funds. What are they, and should you invest in them?

An exchange-traded fund is exactly what it says: a fund (mix of securities) that sells on a stock exchange. A regular mutual fund has its price re-computed at the end of the day by looking at the value of all of the securities that are in it; shares of an ETF, on the other hand, are actually bought and sold themselves. This seemingly small change can make all the difference in the world:

  • ETF’s often (but not always) have lower expense ratios than their corresponding indexes. Why? Because a mutual fund firm has to deal with a lot of paperwork when mutual funds are bought and sold, because they are the ones that have to process it. Not so with an ETF; since they’re sold on a stock exchange, the brokers do all the work there. (The ETF has some work to do — I’ve sidestepped the whole issue of how the price is maintained — but it’s comparatively small peanuts.) This alone can be a good reason to invest in ETF’s, as expense ratios are just about the only way to differentiate between funds that follow the same index, but that advantage comes with several less-obvious disadvantages:
  • ETF’s often (but not always) have commissions. Since you have to buy and sell ETF’s through a brokerage like Schwab or Fidelity, they’ll often charge you a commission to make the trade. If you’re putting a part of your paycheck into an IRA every month, this can quickly eat up any gains you may have gotten over an index fund (and then some!). However, many of the ETF’s most investors are interested in are offered commission-free by the broker; you just have to be careful what you buy. (Of course, mutual funds often have commissions, too.)
  • ETF’s are very difficult to auto-invest. As of this writing, the only popular brokerage I know of that allows you to automatically invest in an ETF is ING’s Sharebuilder, which, while cheap at $4 per automatic investment, is not commission-free. The others only allow automatic investment for mutual funds. Of course, if your ETF has a commission, you probably won’t be automatically investing monthly anyway; likely, you’ll save up in a money market account every month, then invest in ETF’s once every three or four months, so you’re only charged the commission three or four times a year. Either way, it’s not as easy as mutual funds.
  • ETF shares are generally more cumbersome to trade. With mutual funds, you just tell your mutual fund company how many dollars of your funds you want to buy, sell, or exchange (in the case of rebalancing), and the firm takes care of it all at the end of the day, no muss, no fuss. With ETF’s, if you’re rebalancing, you have to sell the shares from the too-high ETF, wait for everthing to clear, then buy the shares from the too-low ETF. And in the meantime, because you can only buy whole shares, you’ve got money piling up in your money market account, leftover from each trade. On the whole, annoying.
  • ETF’s have a bid/ask spread. Because they’re traded on an exchange, there’s a small amount of “friction” involved in buying or selling an ETF, in the form of a bid/ask spread. The more you trade, the more the spread will eat into your returns. Mutual funds do not have this problem.

So, are all the disadvantages worth the lower expense? They can be; however, it’s worth it to sit down and plot out how much you would save in dollars per year if you moved from an index fund to an ETF, and make your decision based on that.

(One note: if you use Vanguard (and I highly recommend you do), there’s virtually no reason to use an ETF. Why? Because they recently lowered the minimum for purchasing Admiral Shares of many of their funds to $10,000, making them very accessible, and in just about every instance, the expense ratio for Admiral Shares is exactly that of the corresponding ETF!)

Got a preference? Tell us about it in the comments!

but it’s on sale: how not to save yourself broke

Getting a bargain is a great feeling, isn’t it? In fact, I know some people who flat out refuse to buy anything at retail price. (And that’s not a bad goal, as far as it goes.) But there’s a danger — I think the cartoon says it better than I ever could:

Madison Avenue knows how we think, doesn’t it? We’re so wrapped up in how much we’re saving, we forget how much we’re spending in the first place. And it’s not just retail: Discover  is fond of sending offers for e.g. $500 cash back if you spend $3000 on their card every month for six months. American Express Blue Cash used to have a little gauge on their site that would show you how close you were — and how much more you would need to spend! — in order to make your cash-back goal.

The worst part: sometimes we do it to ourselves with almost no encouragement. For example, we hate to pay taxes — so we hold on to risky stock from our employer until it becomes a qualifying disposition, or we refuse to sell a well-performing stock for fear of capital gains (or alternately sell a temporarily underperforming one to lock in capital losses!). Now, sometimes this is the wise choice…but all too often, we make the decision in favor of “less tax” without giving the matter enough thought.

Of course, it’s not that humans are stupid — it’s that cognitive bias can often turn us into our own worst enemy. So what’s a poor, irrational human to do? To start:

  • First and foremost: stick to your budget in the face of sales. The envelope method makes this ridiculously easy — when you see a sale at Nordstrom’s or Fry’s, look in your envelope. If you have the money, great! Now you really can buy a little extra with the money you’re saving! If not, well, there will be other sales on other days. Either way, you can rest easy in the knowledge that you’re not saving yourself broke.
  • Think about money in absolute terms. Don’t think about how much you’re saving — think about how much you’re spending. When looking at a tax decision, treat the money you save in taxes as equal in importance to e.g. the money you make by selling that stock.
  • If you like bargain hunting, save up for seasonal sales. Lifehacker has a guide on when to buy anything — check it out!
  • Learn to negotiate — it’s like creating your own, personal “sale” on the spot!
Got any thoughts on sales? Drop a comment below!

a challenge to rich non-budgeters

Last week, we talked about prescriptive and descriptive budgeting — “I Will” versus “It Is.” I did this because they’re useful concepts, but mostly, because I have a challenge for those I call “100% descriptives”.

First, though: descriptive budgeting can be a wonderful goal to strive for. For many people, financial success is defined as freedom — the ability to spend what they want, without worry. By working to increase discretionary income — in large part by paying off old debt and avoiding new debt — this can become a hard-won dream-come-true. And you’ll know that you got there when all of your nearly spending categories become descriptive — they are what they are, and you don’t need to cut back on them in order to meet your goals.

However, your budget should never be 100% descriptive. I have friends who are pretty much there, and some of them can’t stand the idea of budgeting. They don’t like “putting labels on money”. They have enough, so why bother? Why not just make the choices as the desire arises? I have a few answers for that:

How you budget your each dollar determines where you keep it.  If you don’t have a budget to help you make good choices as to how much you keep in checking, savingsCD’s, a retirement account, a 529, or a traditional brokerage account, you end up with:

  • money in your checking account that should be in savings, earning better interest
  • money in your savings account that should be in a brokerage account, earning better long-term returns (if invested properly)
  • money in a retirement account that should be in a 529, allowing you to save for your children’s college education without jeopardizing your retirement
  • money in a brokerage account that should be in a retirement account, not getting taxed
  • money in your employer’s stock that should be in checking or savings, avoiding unnecessary risk

and so on. I see a new example of misplaced money every day, and in each case, they’re losing money, and lots of it — in terms of taxes, interest or capital gains lost, unnecessary risk taken, etc. How much is it worth not to even bother taking stock of your values, or what you might wish you had saved for in ten years?

Money that doesn’t get budgeted often get spent for you. By this, I mean that it goes towards things you don’t really value. The thought occurs to you to buy something, and you shrug and say, “I’ve got the money; why not?” So you accumulate stuff and experiences as the thought occurs to you, rather than thinking about what you truly value. (Note: this is not to knock spontaneity — just as long as it fits with your values!) You spend money way out of proportion to the value you get out of it, and still end up with a vague feeling of unhappiness…so you spend even more money next time, and the cycle continues.

You leave a huge legacy that you didn’t intend. Maybe you don’t spend your money…so you die sitting on a pile of cash. Now, again, a legacy can be a good thing — if it’s planned. However, I’d take a serious look at “Die Broke“; in it, Stephen Pollan makes some excellent arguments for building your legacy while you’re still alive. Certainly this is the case if you have children or grandchildren; in the former case, why not help them out with their first house, their first child, their new business, rather than waiting until you pass on? In the latter, why do them and the world the disservice of making them spoiled “trust-fund babies”?

Your money gets burned by inappropriate investments. What does everyone say you should do with “leftover” money? Why, invest it, of course! So you play around with the stock market, or you have a friend who has this great investment opportunity, or you accumulate ridiculous numbers of shares in your employer’s company…but you have no plan, so when you actually need the money, it happens to be at a low point in that investment’s cycle. (Or, worst case, that “investment opportunity” goes up in smoke!) So you “sell low”, defeating the whole purpose of investing in the first place! (Unless you just enjoy gambling, in which case there’s this whole city I know that’s pretty much built around exactly that…)

So do you have to budget every penny? No. You don’t have to become a spreadsheet junkie with hundreds of budget categories who meticulously enters their transactions every week. Just keep an eye on your finances. Think about what you value. Don’t be afraid to put labels on your money — and to move those labels around as circumstances and your values change!

Your money — and your future self — will thank you.