A Review of the Best Low Cost Stock Index Fund Strategies

After tax season, a number of friends, colleagues and clients at Glassman Wealth Services asked me what they could do to reduce their taxes next year. While I’m not a tax professional, I certainly pay attention to tax rules and rates. This got me thinking about stock investing and the easiest way to keep more of your hard earned money. My short answer to this question was as follows – create a portfolio of low fee, thoughtfully constructed stock index mutual funds or exchange-traded funds (ETF). To do this, I put together this review of the best low cost stock index fund strategies.

Defining ETFs

Many people don’t understand what exchange-traded funds (ETFs) are or how they work. An exchange-traded fund holds investments, such as stocks, bonds or commodities, but is traded on the stock exchanges, just like a stock. ETFs are generally created to track a specific exposure such as the Dow Jones 30 stock index or a broad bond or commodity index. Unlike actively managed funds, ETFs don’t try to beat the market; they aim to reproduce the market’s results, less their fees. So rather than trying to buy all of the stocks in the Dow Jones 30 or S&P 500 stock indexes, you could simply own an ETF that tracks that index.

To get you started, I suggest you consider these 3 important recommendations before buying an index fund or ETF:

1. Decide What You Want to Own:

This may sound obvious, but it’s important to decide what exposure and what markets you want to own. Is your goal to own large stocks, small stocks, both? Do you want U.S. stocks, international, emerging market, or all of the above?

To gain broad stock market exposure in your portfolio, consider investing using an index ETF or mutual fund. Why? Two reasons:

1. These investments are structured with clearly defined market exposures in mind
2. The fees can be incredibly low

Choosing from the broad number of stock index providers can be overwhelming (Dow Jones, Standard & Poors, Russell, MSCI, FTSE, etc.). Therefore, it’s critically important to understand what markets, countries, regions, industries, sectors and stocks are included in the index fund you buy. Some strong resources to consider include ETF.com and Morningstar.com.

2. Consider Fees & Tracking:

Like actively managed mutual funds, every index fund and ETF has associated management fees. These fees can range from more than 1.0% to as low as 0.04% per year. The lower your investment fees, the more of the returns you’ll keep. As such, the lower the fee the better.

There are a couple of caveats:

• First, it’s important that the fund/ETF tracks the index to which it’s supposed to adhere closely. The better the ‘tracking’, the more closely the investment will match that of the desired exposure.
• Second is liquidity, or put simply, how easy is it to buy and sell the investment. With mutual funds, this is not an issue because they are bought or sold at the end of each day. For ETFs, which are traded like stocks, their liquidity is a more important issue. If it is thinly traded, it may become costly to buy and sell this investment.

3. Pay Attention to Taxes:

Taxes are another important consideration. There’s a term, ‘turnover’, which measures how frequently stocks are bought and sold within a portfolio. The higher the turnover, the greater the frequency of buys and sells. Excess activity creates the potential for more taxable gains with the risk being that these are distributed at year-end as short-term or long-term capital gains, triggering a tax liability. This is only an issue for taxable accounts.

I focus on a term called Tax Cost Ratio, which measures how much of a fund’s return is reduced by the taxes an individual would have to pay on distributions. Tax cost ratio, in simplest terms, is a measure of how much of your gains were lost due to the impact of dividends and the selling of stocks. The lower this number, the better. Morningstar, an industry leader in tracking investments, offers this information for free on their website at Morningstar.com.

A Review of Recommended Solutions:

Now that you know what you should consider before investing in index mutual funds or ETFs, here are 4 stock index investments for your consideration:

Broad US Stock Market: Schwab U.S. Broad Market (ticker: SCHB)
Portfolio: Diversified exposure across 2000 large and small cap U.S. stocks
Current yield: 1.74% (as of 6-6-14)
Expense ratio: 0.04%
3-Year Tax Cost Ratio (as of 5-31-14): 0.75
Additional Schwab ETF Information

S&P 500 Index: Vanguard S&P 500 Index Fund (ticker: VFINX)
Portfolio: Seeks to track the performance of the S&P 500 stock index.
Current yield: 1.81% (as of 6-6-14)
Expense ratio: 0.17%
3-Year Tax Cost Ratio (as of 5-31-14): 0.46
Additional Vanguard S&P Index fund information

International Stocks: Vanguard Total International Stock (ticker: VGTSX)
Portfolio: Seeks to track the performance of a broad, international index comprised of approximately 5500 stocks (83% are in developed countries, 17% in emerging countries).
Current yield: 2.8% (as of 6-6-14)
Expense ratio: 0.22%
3-Year Tax Cost Ratio (as of 5-31-14): 0.85
Additional Vanguard Total International Stock fund information

Emerging Market Stocks: iShares Emerging Markets (ticker: EEM)
Portfolio: Seeks to track the performance of the MSCI Emerging Markets index, comprised of greater than 800 stocks in 16 countries.
Current yield: 1.98% (as of 5-31-14)
Expense ratio: 0.67%
3-Year Tax Cost Ratio (as of 5-31-14): 0.43
Additional iShares Emerging Markets ETF information

Investors who desire broad stock market exposure will be well served considering the above mutual funds and ETFs. Both are very effective at accomplishing the dual objectives of high tax efficiency and low cost.

If you would like more information, I put together this short list of helpful resources. You can also talk to us about these strategies by Contacting Us.

Other Useful Resources:

Vanguard Mutual Funds: www.vanguard.com
iShares ETFs: www.ishares.com
Schwab ETFs: www.schwabetfs.com
ETF.com: www.etf.com
Morningstar: www.morningstar.com