How Much Should We Pay For Simplicity In ETF Investing?

| About: Vanguard Total (VT)

Summary

Vanguard offers the cheapest ETF that covers the entire world of investable stocks, the Vanguard Total World Stock ETF with an expense ratio of 0.11%.

While its simplicity is alluring, an investor is paying a price for that convenience.

By investing in two or three different ETFs instead, investors can lower their expenses or add active management into the mix.

Investment Thesis

I'm in the process of simplifying the investments in one of my retirement accounts. At first glance the Vanguard Total World Stock ETF (VT) is very tempting, but after a closer examination, there appear to be better alternatives. By combining a U.S. total market ETF, an international developed markets ETF, and an emerging markets fund, I will be able to reduce expenses and/or add active management into the mix.

Background

I have two baskets of investments spread out between retirement and taxable accounts. In one basket I pick individual securities; I enjoy the process and it has added a small amount of excess returns, historically. The other basket consists of investments managed by others: ETFs and active funds.

One of my retirement accounts is long overdue for an overhaul and I plan on doing it in the coming week. I had originally selected several index and active mutual funds in that account years ago, but am going to transition primarily to ETFs. My goal with this account is broad equity exposure that approximately matches the market, while keeping expenses very low.

My first thought was to use a single ETF from Vanguard that owns most of the investable universe.

Vanguard Total World Stock ETF

Ticker: VT

Expenses: 0.11%

Index: FTSE Global All Cap Index

The Vanguard Total World Stock ETF is designed to be a one-stop shop for equity investing, as it covers U.S. and international stocks in both developed and emerging markets. It contains 7,849 stocks that span the spectrum from large cap to small cap. According to Morningstar, the approximate regional breakdown of the ETF is 53% U.S. stocks, 40% non-U.S. developed markets, and 7% emerging markets.

The Vanguard Total World Stock ETF has a lot going for it. It is managed by the pioneer of index investing and its 0.11% expense ratio is cheaper than anything else in the world stock category. The most appealing aspect of all is the sheer simplicity of it: one ETF that captures the entire equity market, or close to it.

I was definitely tempted, but after looking around and seeing the incredibly low 0.03% expense ratios of the leading U.S. total market ETFs, I got to wondering if I couldn't capture the whole equity market in a better and cheaper way.

Two ETF Approach

There is currently a price war under way in the ETF market, although it doesn't seem to have touched the world stock sector. Schwab (NYSE:SCHW) and Blackrock (NYSE:BLK) are aggressively competing with Vanguard's prices in the U.S. and international ETF categories.

Vanguard's top offering in the U.S. large blend category, for instance, comes in at 0.04%. Schwab and Blackrock both have offerings at 0.03%.

  • The Schwab U.S. Broad Market ETF (SCHB) tracks the Dow Jones U.S. Broad Stock Market Index which consists of the largest 2,500 stocks in the U.S. stock market, although the ETF only owns 2,023 of those stocks.
  • The iShares Core S&P Total U.S. Stock Market ETF (ITOT) tracks the S&P 500 and the S&P Completion Index and contains 3,610 stocks. The additional stocks beyond the 2,500 in the Dow Jones index are primarily micro-cap stocks and make up only about 1% of the market.

The top two international total market ETFs both have an expense ratio of 0.11%, and are offered by Vanguard and Blackrock.

  • The iShares Core MSCI Total International Stock ETF (IXUS) tracks the MSCI ACWI ex USA Investable Market Index, which consists of 6,195 large, mid, and small cap stocks in both developed and emerging markets. The ETF uses a sampling method and holds 3,350 stocks.
  • The Vanguard Total International Stock ETF (VXUS) tracks the FTSE Global All Cap ex U.S. Index and owns 6,176 large, mid, and small cap stocks in both developed and emerging markets.

On balance, the two ETFs in each group are so similar as to be indistinguishable, but if had to choose two of them and I wasn't receiving commission free trades on one fund family, I would pick ITOT and VXUS for their larger number of holdings.

53% iShares Core S&P Total U.S. Stock Market ETF 0.03%
47% Vanguard Total International Stock ETF 0.11%
combined 0.068%

The breakdown of the Vanguard Total World Stock ETF is 53% U.S. and 47% non-US, so if we combined these two separate funds at the same ratio, we get expenses of roughly 0.07% instead of 0.11%.

Two ETF Plus One Approach

We've managed to shave 4 basis points off my passive equity exposure and it seems to have cost me very little. I noticed that there were offerings in the international developed markets subgroup with expense ratios of 0.06% and 0.07%. I decided to see if I could separate the developed and emerging markets into two separate funds and get an even lower expense ratio.

While the Schwab International Equity ETF (SCHF) comes in at 0.06%, it achieves its lower expenses in part by not including small cap stocks. I decided that I would rather look at the two 0.07% offerings that contain small caps.

  • The iShares Core MSCI International Developed Markets ETF (IDEV) tracks the MSCI World ex USA Investable Market Index which consists of 3,508 stocks that captures 99% of the market cap of the 22 developed markets besides the U.S. The ETF uses a sampling technique for efficiency and has 1,195 holdings.
  • The Vanguard FTSE Developed Markets ETF (VEA) tracks the FTSE Developed All Cap ex U.S. Index and owns 3,821 large, mid, and small cap stocks in the non-U.S. developed markets.

In the diversified emerging markets group, there is a clear expense winner with the Schwab Emerging Markets Equity ETF (SCHE) at 0.13%. But just as in the foreign large blend space, it achieves this superior expense ratio in part by excluding small cap stocks. So my preference is to use one of the two 0.14% expense ratio options that include small caps.

  • The Vanguard FTSE Emerging Markets ETF (VWO) tracks the FTSE Emerging Markets All Cap China A Inclusion Index and contains 4,619 holdings.
  • The iShares Core MSCI Emerging Markets ETF (IEMG) tracks the MSCI Emerging Markets Investable Market Index with 2,687 constituents. The ETF itself only contains 1,886 stocks, however.

Of the two in each category, I'd prefer to use the Vanguard funds. When in doubt, I'd rather have an ETF that owns all of the stocks in the index rather than one that owns a representative sample, but the results of both ETF families will be similar.

If we combine ITOT, VEA, and VWO at the ratio of 53% U.S. stocks, 40% non-U.S. developed markets, and 7% emerging markets, we get an impressive expense ratio of just over 0.05%.

53% iShares Core S&P Total U.S. Stock Market ETF 0.03%
40% Vanguard FTSE Developed Markets ETF 0.07%
7% Vanguard FTSE Emerging Markets ETF 0.14%
combined 0.054%

By using three ETFs instead of just the Vanguard Total World Stock ETF, we have cut our expenses in half. Granted, the difference between 0.11% and 0.054% is small in absolute terms, but it is not irrelevant. And while these are the three ETFs that I selected to achieve this expense reduction, it can be accomplished with three Vanguard ETFs, three iShares ETFs, or three Schwab ETFs. If any of those fund families offer commission free trades at your particular brokerage, then they would be the best choice for you.

To get an idea of what that difference could be paying for, let's look at another scenario where instead of using an emerging market ETF, we use an active emerging market fund.

Active Management In Emerging Markets

There continues to be some debate about whether active management in aggregate beats passive management in the emerging markets space. I've read academic papers, studies, and articles that portray both sides as victors. I do think that the premise that investors can't find an above average manager is flawed. In an earlier article on active funds, I discuss how I look for competitive expenses and no 12b-1 fees, a small number of holdings to eliminate closet indexers, and managers who invest in their own funds so that the interests of the manager and the investors are more closely aligned.

I am currently invested in an emerging markets fund run by Seafarer and over the course of my reallocation, I may decide to add to my position and convert to the institutional shares of the Seafarer Overseas Growth and Income Fund (SIGIX). These shares have an expense ratio of 0.98% and I expect the returns for the fund to continue to exceed the emerging markets indexes.

53% iShares Core S&P Total U.S. Stock Market ETF 0.03%
40% Vanguard FTSE Developed Markets ETF 0.07%
7% Seafarer Overseas Growth and Income Fund Institutional Shares 0.98%
combined 0.113%

This combination of two ETFs and a mutual fund covers the entire spectrum of investable stocks and has roughly the same expense ratio as the Vanguard Total World Stock ETF. In this situation, we are getting emerging markets stock picking expertise for "free" by exchanging VT for a combination of ITOT, VEA, and SIGIX.

Many index investing purists would never dream of paying 1% for an active emerging markets fund, but also wouldn't bat an eyelash at paying 0.1% for the total market. There are situations where active management makes sense and this may be one of them.

Pros and Cons

There are pros and cons to owning a single fund vs three funds for your equity exposure.

On the one hand, owning a single fund means truly being able to set it and forget it. An investor who owns the Vanguard Total World Stock ETF will never have to rebalance between U.S. and international, or between developed and emerging markets.

On the other hand, owning three funds allows an investor to have lower expenses, active management in the emerging markets space, or possibly both. And while rebalancing can sometimes feel like a chore, owning three funds does give an investor the ability to easily overweight one of the three groups. This can be both a blessing and a curse: while it can be used to express a macro opinion when one segment of the total market is undervalued or offers superior growth, it also opens up the possibility of investor error.

Finally, the expense ratio of today is not necessarily the expense ratio of tomorrow. If the ETF price war spreads to the world stock group, then VT or a competing product might yet become the correct choice.

Conclusion

A combination of a U.S. total market ETF, a non-U.S. developed markets ETF, and either an emerging markets ETF or an active emerging markets fund is currently superior to a one-stop shop like the Vanguard Total World Stock ETF. When I reallocate the funds in one of my retirement accounts in the coming week, I intend to use the "two ETF plus one" approach. I'm still undecided about whether to go with the lowest expense ratio possible or with the "free" active management in emerging markets, though, and I'd be interested in hearing readers' thoughts before I make my decision.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ITOT, VEA, VWO, SIGIX over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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