2 Helpful Tips For Comparing ETFs

Includes: EEM, EFA, HYG, LQD, VWO
by: The Financial Lexicon

In recent years, the growth of exchange-traded funds (ETFs) has been phenomenal. According to BlackRock's "ETP Landscape Industry Highlights Q1 2012," the number of ETFs has absolutely exploded, from 92 in the year 2000 to a whopping 3,169 at the end of the first quarter of this year. In terms of assets under management, ETF assets have grown from just $74.3 billion in 2000 to a bit more than $1.5 trillion in Q1 2012.

With the increasing popularity of ETFs and the ever-growing number of choices available to investors, I thought it would be helpful to provide readers with a few simple, yet a bit unconventional, tips for comparing ETFs. Of course, information such as expense ratio, geographic and sector diversification, yield, and performance relative to the index it tracks are all important things to research when selecting an ETF. With respect to fixed income ETFs, you'll also want to pay attention to maturity and duration profiles as well as the credit quality of the portfolio. Furthermore, when you are ready to purchase an ETF, it is also important to pay attention to the premium or discount to net asset value at which an ETF is trading.

This type of information is the standard mix found in many articles providing research on various exchange-traded funds. However, there is other useful information to keep in mind when deciding among various ETFs for your portfolio. What follows are two such examples:

1. With respect to ETFs, Qualified Dividend Income (QDI) refers to dividends that qualify for the lower dividend tax rates for which investors are currently eligible. It is important to understand that some ETFs pay out dividends that do not qualify, in part or in whole, for the lower dividend tax rates. Instead, that portion of your dividends that are considered non-qualified dividends will be taxed at ordinary income tax rates. As I will illustrate below, sometimes ETFs with very similar benchmarks can have vastly different QDIs. And this can create enormous differences in terms of the effective tax rate an investor ends up paying on the dividends.

For example, let's compare the 2011 QDIs of Vanguard's MSCI Emerging Markets ETF (NYSEARCA:VWO) and iShares' MSCI Emerging Markets Index Fund (NYSEARCA:EEM). Last year's QDI for Vanguard's MSCI Emerging Markets ETF was 62.01%. On the other hand, iShares' MSCI Emerging Markets Index Fund had a 2011 QDI of 91.55%. There is no way to know for sure whether those numbers will carry forward to 2012. But for illustrative purposes, I would like use last year's QDIs and dividend distributions to show how QDI differences even between very similar funds can dramatically change one's effective tax rate on the dividends.

Last year, VWO made one dividend distribution of $0.906 while EEM had two dividend distributions totaling $0.80788. To make the comparison a fair one, we need to ensure equal dollar amounts, or as close to that as possible, for a hypothetical cost basis in the ETFs. Assuming one investor purchased 1,039 shares of VWO at 2010's closing price, that investor would have spent $50,023.69 (ex-commissions). Similarly, an investor purchasing 1,050 shares of EEM at 2010's closing price will have spent $50,024.10 (ex-commissions). These two totals are close enough for comparison's purpose.

In 2011, a 1,039 share position in VWO would have generated dividends of $941.33. A 1,050 share position in EEM would have generated $848.27 in dividends. As I stated above, 62.01% of VWO's dividend qualifies for the lower dividend tax rate. Assuming an investor in the 35% tax bracket owned those shares, the tax liability on VWO's dividends would have been $212.72. Here's how to calculate that tax liability:

  • $941.33 × 62.01% = $583.72 (this is the amount of the dividend considered QDI)
  • $583.72 × 15% (qualified dividend tax rate) = $87.56
  • $941.33 − $583.72 = $357.61 (this is the amount of the dividend not considered QDI)
  • $357.61 × 35% (ordinary income tax rate) = $125.16
  • $87.56 + $125.16 = $212.72 (this is the amount owed in taxes on the $941.33 in dividends)

Now let's perform the same calculation for the investor with 1,050 shares of EEM, dividends of $848.27, and a QDI of 91.55%:

  • $848.27 × 91.55% = $776.59 (this is the amount of the dividend considered QDI)
  • $776.59 × 15% (qualified dividend tax rate) = $116.49
  • $848.27 − $776.59 = $71.68 (this is the amount of the dividend not considered QDI)
  • $71.68 × 35% (ordinary income tax rate) = $25.09
  • $116.49 + $25.09 = $141.58 (this is the amount owed in taxes on the $848.27 in dividends)

To summarize, the VWO investor would have paid $212.72 on $941.33 in dividends, an effective tax rate of 22.60% on those dividends ($212.72 divided by $941.33). The EEM investor would have paid $141.58 on $848.27 in dividends, an effective tax rate of 16.69% on those dividends ($141.58 divided by $848.27).

If you are a cost-conscious investor focused solely on the expense ratios of the two funds, currently 20 basis points for VWO and 67 basis points for EEM, you might not realize that the difference in QDI between the two ETFs wipes out a large portion of the higher expenses charged to EEM investors. In fact, when combining this with my second tip for comparing ETFs, depending on your broker, you may be able to completely wipe out that higher expense ratio, making EEM the cheaper buy.

2. If you are an investor who dollar-cost averages into positions over time, you will certainly want to be aware of the repeated cost of building those positions through commissions charged on each trade. For such investors, it would be useful to research whether your broker offers free trades (i.e. no commissions) for certain ETFs. This could save you lots of money over a period of years depending on how much buying you plan to do.

For investors with brokerage accounts at Vanguard, there are no commissions on trades involving Vanguard ETFs. However, Vanguard may restrict you from purchasing a Vanguard ETF for 60 days if you've bought and sold that ETF in a Vanguard brokerage account more than 25 times in a 12-month period.

Another retail broker that offers free trades on ETFs is Fidelity. Fidelity currently offers no commissions for online trades of 30 different iShares ETFs. These include the two very popular corporate bond ETFs, HYG and LQD, which have more than $17 billion and $24 billion respectively in total net assets. It also includes the iShares MSCI EAFE Index Fund (NYSEARCA:EFA), which has more than $36 billion in total net assets, and the aforementioned iShares MSCI Emerging Markets Index Fund. If you want to trade these ETFs for free on an ongoing basis, Fidelity is the place to do it.

Charles Schwab also offers free ETF trades to its clients. Schwab brokerage clients can trade Schwab ETFs online commission free.

If your brokerage account is not with a broker that offers free trades on ETFs, you may still be able to secure free trades through one of the many deals retail brokers occasionally offer clients. Over time, trading for free could save the investor who dollar-cost averages a noticeable amount of money. Be sure to include commissions in your research when deciding which ETF to purchase.

In closing, I would like to tie together these two tips for comparing ETFs. If you are an investor with, say, a Fidelity brokerage account and are deciding between VWO and EEM, the preferable QDI combined with no commissions on EEM for Fidelity clients will make EEM the cheaper fund. If you are a Vanguard client doing the same comparison, combining EEM's preferable QDI with VWO's no commissions, the scale would still slightly favor VWO from a cost perspective. The next time you are deciding between two or more ETFs tracking similar benchmarks, don't forget to factor in the QDI and commissions associated with those ETFs. The results might surprise you.

Disclosure: I am long HYG. 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.