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Vanguard Joins the Commission-Free ETF Ranks

Low costs keep getting lower.

Paul Justice, 05/10/2010

Vanguard announced last week that it will offer all 46 of its ETFs commission-free on the Vanguard platform. The move comes in response to similar actions taken by Fidelity and Charles Schwab over the past six months, but the Vanguard offering is the most comprehensive yet. The lineup nearly doubles the commission-free partnership that Fidelity inked with iShares, and it offers investors a comprehensive suite of low-cost and transparent index funds in the tax-efficient and liquid ETF wrapper. Because Vanguard ETFs were already separate share classes of existing mutual funds, Vanguard investors have long had the ability to gain the same asset exposure without incurring transaction fees by using the mutual funds. However, investors now have greater flexibility and choice, because transaction costs are out of the mix.

ETFs are often slightly more tax efficient than a comparable index mutual fund, so savvy investors will benefit from this move by having more options. ETFs are particularly effective in taxable accounts, and waiving commissions means that those accumulating assets on a regular basis using ETFs will see their costs diminish substantially.

Vanguard's legacy has been built around low-cost access to well-constructed and diverse funds, so we are not surprised that it chose to offer its own products without trading costs. ETFs have generated substantial growth for the company, both on their own brokerage platform and elsewhere, so they have keen interest in maintaining their low-cost advantage. Most of the Vanguard ETFs compete against very similar products, but when Vanguard wins the comparison battle, it is typically based on all-in costs. As an example, Vanguard demonstrates that investors can achieve and internationally diverse stock/bond portfolio, using only four of its ETF products, that clocks in with just a 0.12% annual fee.

Vanguard likely could have made this move years ago, but they wisely like to discourage rapid trading by investors. Investors en masse tend to diminish their personal returns when they trade frequently. Keeping a transaction cost in place would discourage trading too often, but competitive forces from other brokerage houses likely forced their hand. The firm reserves the right to restrict trading in an ETF if an investor makes more than 25 trades in the same product over a 12-month period. In this regard, Vanguard keeps some of its historic paternalism in place.

When compared with the Fidelity move, I see two advantages in Vanguard's camp. First, Vanguard's product lineup of all 46 ETFs is more extensive than the 25 iShares products offered for free by Fidelity. Also, by being both the issuer of the ETFs and the brokerage operator, Vanguard has not run into any margin-eligibility issues. Many Fidelity customers were irked when they learned that their margin capability was hampered when using any iShares product due to the joint marketing arrangement. However, the iShares products largely maintain liquidity advantages over Vanguard's, a clear benefit of iShare's first-to-market advantage.

Schwab's offering is very competitive based on all-in costs, but its product lineup remains extremely small compared with Vanguard's. Not only is the number of products extremely limited, but the funds are also considerably less liquid. We note, however, that Schwab's products have been extremely successful at gathering assets in a short period of time, considering that the eight products have already gathered $1.2 billion in assets under management since their November 2009 launch. We would expect that figure to increase, because it is estimated that nearly 20% of all assets invested in ETFs clear through the Schwab platform. However, Vanguard has already gathered $108 billion in assets under management in its ETFs--$24 billion alone sits in Vanguard Emerging Markets Stock ETF VWO.

Commissions are but one small expense in relation to the all-in costs of investing. By no means should investors simply dump their current holdings and move to an all-ETF portfolio at Vanguard because the trading fees have been removed from the equation. The tax consequences of selling current holdings would likely dwarf the miniscule tax-efficiency benefits that cap-weighted ETFs hold over similarly structured mutual funds, if you are fortunate enough to have long-term capital gains on your current holdings. Furthermore, even if you are an existing Vanguard customer, you still need to do your homework to ensure that you are getting the product that both meets your investment needs and delivers the lowest possible cost.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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