The finance blogosphere has been ablaze the last week with Vanguard’s announcement that they’ll be eliminating trading fees on an enormous swathe of ETF’s that currently cost $7 to buy and sell. Reducing transaction fees is an unalloyed good for investors, but I think there are some interesting additional consequences of the change to think about.
On July 2, Vanguard announced that “nearly 1,800” ETF’s would be offered with no transaction fees through the Vanguard platform, beginning “in August.”
Vanguard already offered its own ETF’s commission-free, so this seems like an attempt by Vanguard to move more non-Vanguard ETF trading onto their own platform; folks who used Vanguard to trade Vanguard ETF’s, but used a Fidelity or Merrill Edge account to trade non-Vanguard ETF’s, like iShares and SPDR’s, may be tempted to move more of their assets into a single Vanguard brokerage account.
Aside: Why ETF’s?
People who invest in taxable accounts sometimes prefer ETF’s to mutual funds because when mutual funds see investor redemptions they’re sometimes forced to sell their underlying holdings and pass along any accrued capital gains tax liability to the remaining shareholders, while ETF’s use a financial engineering process called “creation and redemption” to avoid passing along capital gains to shareholders. I don’t think this is very interesting but people who distribute ETF’s think it’s incredibly interesting, so I want to make sure you’re aware of it.
This could be a Robinhood-killer
I like using the Robinhood iPhone app to trade individual shares of stocks and ETF’s without commissions. But with commission-free ETF’s through Vanguard, there’s no reason to use Robinhood to buy and sell those shares, so Robinhood will get a smaller percentage of my recreational trading business [Disclosure: I own one share each of WisdomTree’s DHS, iShares’ QAT, ERUS, and TUR, and two shares of Cambria’s TAIL].
Robinhood has two key problems as an investment platform: it only offers taxable brokerage accounts, and it doesn’t offer the benefits of a full-service taxable brokerage account. While Vanguard allows you to easily identify specific shares for sale, making it possible to harvest capital losses in some years, gains in others, or both to offset each other, Robinhood just doesn’t have that functionality, at least not yet.
On the flip side, while Vanguard’s full-service taxable brokerage platform makes it easy to maximize the tax benefits of price fluctuations, they also charge transaction fees for non-Vanguard ETF’s, meaning every time you harvest a loss or gain, or simply make a periodic contribution to a non-Vanguard ETF, you’re surrendering some of the benefit of the platform back in transaction fees.
Using Vanguard as your primary taxable brokerage account is going to make more sense
While Vanguard offers a wide range of ETF’s, understandably they don’t offer very many overlapping, tightly correlated ETF’s, which is one of the fundamental principles of tax-loss harvesting.
When you sell an asset in a taxable account that has declined in value, if you want to maintain exposure to the asset class, you need to find a not-substantially-identical asset to buy in order to avoid the “wash sale” rule. But within a single fund family, those are relatively rare. Vanguard offers VTI (Total Stock Market) and VOO (Vanguard S&P 500), for example, but they don’t offer a foreign total-market and foreign large-cap ETF, or emerging market total-market and emerging market large-cap ETF.
What the addition of no-transaction-fee non-Vanguard ETF’s brings is the ability to do far more such matching trades in taxable brokerage accounts. For example, the Vanguard FTSE Emerging Markets ETF (VWO), as you’d expect, tracks the FTSE emerging markets index, while the iShares MSCI Emerging Markets Index (EEM) tracks the MSCI index. The main difference is the exclusion of South Korea in the former and its inclusion in the latter. Since they’re not substantially identical (South Korea’s a big country!), they make a great tax loss harvesting trade.
I don’t think taxes are that interesting so I don’t think you should spend too much time obsessing over this stuff, but for those who are willing to put in the work these fee-free transactions potentially offer a lot of opportunities to harvest losses during choppy markets without the friction of transaction fees.
Vanguard doesn’t offer custodial services to advisors
One reason folks in the finance world have been spilling so much ink over Vanguard’s announcement is that Vanguard doesn’t have a full-service custodial platform for financial advisors, which creates a dilemma: in order to take advantage of opportunities to harvest losses and rebalance portfolios, advisors want to have a full-service trading platform, but in order to best serve their clients, they also want to have a low-cost trading platform.
There’s no one right solution to this problem, but hopefully Vanguard’s aggressive move will encourage the existing custodial platforms to lower or eliminate trading fees for ETF’s on their own platforms.
No-transaction-fee ETF’s in qualified retirement accounts
So far I’ve been talking about the tax benefits of access to more no-transaction-fee ETF’s in taxable brokerage accounts, but of course most people have the majority of their financial assets in qualified retirement accounts where things like capital gains distributions and tax loss harvesting are irrelevant.
In those accounts I think there’s opportunity for both mischief and profit. If no-transaction-fee ETF’s cause people to buy too many, too-expensive ETF’s from too many issuers, they’re going to end up with something that looks a lot like the market’s performance, minus the additional expenses paid to their menagerie of funds.
On the other hand, if investors want to pursue a specific investment thesis, or execute a specific hedge, in their retirement accounts then being able to do so without the friction of transaction fees could save them tens or hundreds of dollars per year.
To be clear, lower transaction fees are an unalloyed good, for the obvious reason that transaction fees cost money, and the more money you spend on transaction fees, the less money you have left afterwards.
But whether you, in particular, should be jumping all over no-transaction-fee ETF’s starting in August instead of making steady contributions to a portfolio of low-cost mutual funds depends on your specific situation.
In other words, just because you can trade for free doesn’t mean you should trade for free.