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The latest Vanguard announcement on offering all the company's 46 ETF trades commission free marks a new era for ETFs. In our opinion, with trading costs removed, ETFs are now a viable alternative to index and actively managed mutual funds in portfolio building and asset allocation.

Three brokerage firms, Vanguard, Fidelity and Schwab, have announced commission-free ETFs. Let's first compare them in the following table:

Asset Classes Sub Asset Classes Vanguard Fidelity Schwab
US Equity Large Cap MGC, MGK, MGV, VTI, VTV, VUG, VXF, VV, VIG, VYM IWD, IVV, IWB, IWV, IVW, IWF, IVE SCHB, SCHX, SCHG, SCHV
US Equity Mid Cap VO, VOT, VOE IJJ, IJH, IJK
US Equity Small Cap VB, VBK, VBR IJS, IWN, IJR, IWM, IJT, IWO SCHA
Foreign Equity VT, VEU, VSS, VEA, VGK, VPL EFA, ACWI, SCZ SCHF, SCHC
Emerging Mkt Equity VWO EEM SCHE
REIT VNQ
US Fixed Income Treasury Government VGSH, VGIT, VGLT, EDV, VMBS TIP, MUB
US Fixed Income Corporate VCSH, VCIT, VCLT LQD
US Fixed Income General BSV, BIV, BLV, BND AGG
Intl Fixed Income N/A EMB
Sectors VPU, VOX, VAW, VGT, VIS, VHT, VFH, VDE, VDC, VCR

From the table, one could see that Vanguard commission free ETFs covers most of major and minor asset classes. Schwab, on the other hand, offers limited coverage. Schwab's ETFs have relatively short history but, given Schwab's reputable mutual funds, one would expect these ETFs would offer competitive performance compared with iShares and Vanguard's ETFs.

Among all of the offerings, asset class foreign bonds and commodities are noticeably missing. From diversification point of view, we would like to see those asset classes are covered.

The significance of commission free ETFs should not be understated: periodically rebalancing of a portfolio using strategic asset allocation is now free and at will, no more redemption and round trip charge (though we are not advocating frequent trading), no more lockup period and various fund classes (remember those class A, B, C, D, Y, Z shares?). Commission free ETFs make very good instruments for constructing a portfolio using a good tactical asset allocation strategy. Remember academic research keeps reminding people of the trading cost? It is gone. Now, one could build an ETF based portfolio using some of best tactical asset allocation strategies.

For example, on MyPlanIQ.com, it offers a Vanguard ETFs plan that has several model portfolios based on Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA). The following table shows the comparable performance among VBINX (Vanguard Balance Fund Index, a 60% stock and 40% bond portfolio), SAA moderate portfolio and TAA moderate portfolio. The following illustrates the performance comparison among TAA, SAA and VBINX (click to enlarge).

The performance comparison is as follows:

1 yr AR 1 yr Sharpe 3 Yr AR 3 YR Sharpe 5 YR AR 5 YR Sharpe
Vanguard ETF TAA (P_16707) 27% 1.8 11.6% 0.74 15.6% 1.01
Vanguard ETF SAA (P_15214) 30% 2.06 5% 0.2 10% 0.46
Vanguard Balance Fund Index (VBINX) 18.1% 1.7 -1.75% -0.15 3.4% 0.11

Commission free ETFs are not free of problems. The major remaining issue is the trade friction or so called bid and ask spread: with an index mutual fund, one has no such a problem. This problem is exacerbated by low volumes for some ETFs. Care should be still given for those ETFs. We expect, however, the growing volume and popularity of ETFs will eventually make these problems less serious.

We applaud the recent industry moves and are looking forward to more such moves to make them completely free. We believe this represents a significant step forward to further level playing fields between retail investors and professional investors.

Disclosure: Author holds long positions in SPY, IWN, IJS, LQD, EEM

Source: Commission-Free ETFs Enable Portfolio Building Using Asset Allocation Strategies