Making the Most of Vanguard's VIPERs

Below is an excerpt from the February issue of our Vanguard Fund Family Report. Also note that the February issue of our Fidelity Fund Family Report examined manager ownership of Fidelity funds. The February issue of our American Funds Fund Family Report features five suggestions for American Funds' board of directors. To review a risk-free trial issue of any of our Fund Family Reports,click here.

Given its indexing expertise, Vanguard is a natural fit for the ETF market, which is a focus of growth for the firm. To attract more interest, Vanguard has broadened its slate of VIPERs to 23, and more are certainly on the way.

Vanguard has taken a slightly different tack in creating VIPERs. Other ETFs are stand-alone entities, but VIPERs are organized as separate share classes of the firm's traditional index funds. As a result, the bulk of the VIPER lineup will look familiar to Vanguard investors because they're simply ETF versions of some of the firm's most popular funds.

The Real Benefits
ETFs are often touted for their trading flexibility. But I view it more as a danger than a perk. Just because you can trade options on an ETF or sell it short does not mean you should. So don't get caught up in the hype. Concentrate on the real benefits of ETFs--low costs and tax efficiency.

Let's focus on costs first. When it comes to index funds, the cheaper the better. So ETFs' low costs give them a big edge over the competition. And it comes as no surprise that Vanguard's VIPERs are some of the cheapest ETFs around. But there's a catch. As with stocks, you pay a brokerage commission each time you purchase and sell an ETF. So even a couple of trades each year can completely cancel out an ETF's expense advantage. Consequently, traditional mutual funds are still the best way to go if you plan to dollar-cost average or if you like to rebalance frequently. That's why I think ETFs are most suitable for lump-sum investments that you plan to hold for the long haul. But you need to have a sizable lump sum to realize meaningful cost savings. To get a sense of the dollars involved, let's look at an example.

I used the  Cost Analyzer Tool on Morningstar.com to compare the cost of holding  Vanguard European Stock Index (VEURX) with the cost of  Vanguard European Stock VIPERs (VGK). I assumed a 7% annual rate of return for a 10-year holding period. I also assumed brokerage commission on the VIPERs of $25, which is the standard commission for online trades at Vanguard Brokerage. (That likely understates the total cost of the trade because it ignores the trading spread, which is the cut the market maker takes to process the transaction on the exchange.) For a $10,000 investment, you'd accumulate about $100 more using the VIPERs, based on cost savings and the return earned on those savings. For a $20,000 account, you'd be $272 ahead, and for a $50,000 investment, you'd be up $790.

A Taxing Controversy
ETFs have a good record of tax efficiency, as my colleague Dan Culloton pointed out in a recent article.

However, because VIPERs are separate share classes of traditional index funds, some critics argue that VIPERs will ultimately be less tax efficient than competing ETFs. These critics worry that if a large number of traditional shareholders cash out of a fund, the manager may be forced to realize significant capital gains, and these tax consequences would affect both traditional and VIPER shareholders alike. (For a more detailed discussion of these concerns, click here.)

While it's true that VIPER shareholders may be exposed to slightly more tax risk than other ETF investors, I think the risk is quite small. It would take massive redemptions to trigger big capital gains distributions. Furthermore, Vanguard has a strong track record of running its funds in a tax-efficient manner. In fact, most of Vanguard's traditional index funds have been at least as tax efficient as competing ETFs. For instance, Vanguard 500's long-term tax-adjusted returns are better than all of its ETF rivals. So I wouldn't let tax concerns keep you from taking advantage of what VIPERs have to offer.

Putting VIPERs to Work
Let's say you have a lump sum that you plan to hold for several years. What VIPERs should you use to construct your portfolio? If you plan to allocate a portion of your portfolio to bonds, you'll need to look beyond VIPERs because there are presently no fixed-income options available. Indeed, there are only six bond ETFs in the market, all offered through iShares. I wouldn't be surprised if Vanguard eventually rolled out a bond ETF, but its omission is not a big deal, in my opinion. Because bonds don't generate much in the way of capital gains, bond ETFs won't enjoy the same tax efficiencies as their equity brethren. Plus, the expense ratios on Vanguard's bond funds are quite competitive. For example, with an expense ratio of 0.20%,  Vanguard Total Bond Market Index  (VBMFX) is just as cheap as its ETF rival,  iShares Lehman Aggregate Bond (AGG). And  Vanguard Intermediate-Term Tax-Exempt (VWITX) is even cheaper at 0.16%, and that fund is a better choice if you are in a higher tax bracket and if you plan to invest your lump sum in a taxable account.

Vanguard has plenty of ETF options for the equity portion of your portfolio, but you only need a handful to construct a diversified portfolio. You can cut the choices in half by taking the sector funds off the table. Most are too turbulent to be used effectively. And many sector index funds take volatility risk up a notch because they concentrate their portfolios in their top holdings. Take a look at  Vanguard Energy VIPERs (VDE). The top 10 holdings soak up 61% of assets, and 19% is dedicated to  ExxonMobil (XOM) alone. That exposes the fund to too much stock-specific risk, in my opinion.

For your domestic equity allocation, I'd keep it simple and stick with  Vanguard Total Stock Market VIPERs (VTI). It is darn cheap at 0.07%, and it gives you exposure to the entire domestic stock universe in one fund.

Rather than choosing a no-fuss option like Vanguard Total Stock Market VIPERs, some investors might be tempted to use a combination of VIPERs so that they can tilt their portfolio to a desired market-cap range or style. But I'd urge you to avoid the temptation. If you create a complicated portfolio, you'll need to rebalance more often, which will jack up your trading costs and negate the cost savings that attracted you to ETFs in the first place.

You should also consider allocating a portion of your portfolio to international equities. Unfortunately, no firm offers a broadly diversified ETF that provides one-stop exposure to foreign markets. You can simulate Vanguard's conventional fund,  Vanguard Total International Market Index (VGTSX), by allocating 60% of your foreign portfolio to  Vanguard European Stock VIPERs (VGK), 25% to  Vanguard Pacific Stock VIPERs (VPL), and 15% to  Vanguard Emerging Markets Stock Index VIPERs (VWO).

There you have it. You can construct a fine portfolio with just these four ETFs and a traditional fixed-income fund. It's simple, straightforward, and cheap.