How to Safely Use Vanguard's Arsenal of 'Beautiful Shotguns'

Bogle's Folly is about to become a "beautiful shotgun." In fact, Vanguard now has a closet full of "shotguns" that are more accessible than ever. How do investors use them without collateral damage?

Vanguard's plans to finally add a rock-bottom-priced ETF share class to the  Vanguard 500 (VFINX), the first index mutual fund (which skeptics dismissed as Bogle's Folly when firm founder Jack Bogle launched it in 1976), makes Vanguard an even more interesting place for ETF investing. That may be to the chagrin of Bogle, who once likened ETFs to "beautiful shotguns"--great for hunting, but also good for suicide. Like it or not, though, Vanguard this year has given ETF investors a lot more freedom and flexibility, first by offering commission-free trades on its own ETFs, then by planning to expand its ETF lineup to 66 to include funds tracking S&P and Russell indexes.

With great freedom, however, comes great responsibility. A smorgasbord of some of the lowest-cost, most tax-efficient investments available to retail investors can be had for no brokerage free at Vanguard, but Investors have to be careful not gorge themselves.

ETF Sale
The permanent commission waiver lowers the total costs for ETF investors at Vanguard, and it's especially valuable for those who want to dollar-cost average. Until now, Vanguard's traditional index mutual funds were the natural choice for investors who wanted to make regular purchases every paycheck or month. Why pay the transaction costs for the ETFs, which at Vanguard are share classes of existing index funds, when you could get the same thing without paying a commission? The brokerage charges often neutralized the edge of the ETFs' lower expenses.

Before the new policy, someone with less than $50,000 who wanted to buy  Vanguard Total Stock Market ETF (VTI) had to pay at least $25 per trade. An investor who put $10,000 into the ETF, followed it up with $100 monthly contributions, and earned 7% over the next 10 years would have paid total costs eight times greater than what he or she would have paid in the traditional share class of  Vanguard Total Stock Market Index (VTSMX). In other words, the total price tag of the traditional share class was cheaper, even though its expense ratio was twice that of the ETF.

Without the commissions, however, the tables turn. The traditional version of Total Stock Market is more than 2.5 times as costly as the ETF. So, it's now safe to dollar-cost average into an ETF portfolio at Vanguard. Indeed, many investors now may ask a different question: Why buy the traditional index fund when you can get an often substantially lower expense ratio from the ETF? The average expense ratio of a simple equally weighted three-fund ETF portfolio of Vanguard Total Stock Market ETF,  Vanguard FTSE All-World ex-US ETF (VEU), and  Vanguard Total Bond Market ETF (BND) (0.15%) would be little more than half that of the same portfolio built with the traditional investor share classes of the same funds (0.27%).

Free Trades, but No Free Lunch
The answer still depends on your personal situation, though. You wouldn't, for example, want to swap all your Vanguard index funds for Vanguard ETFs if doing so would incur a huge capital gains tax bill. The ETFs also offer no advantage to investors in the Admiral and Signal share classes of the index funds, whose expenses often are lower than those of the corresponding ETFs. The new brokerage policy, however, does even the total-cost playing field between Vanguard's ETFs and traditional index funds.

Offering free trades, of course, has risks. The biggest peril is the chance that investors will use the vehicles to shoot themselves in the feet by trading too much. Brokerage charges aren't the only factor in the transaction-cost equation. Unlike traditional funds, ETFs have bid/ask spreads, or the difference between what buyers are offering for shares and what sellers are willing to accept. It's often narrow for Vanguard ETFs. Their spreads average just 0.012% on a volume-weighted basis, which puts more emphasis on the family's more frequently free-traded ETFs. Yet the spreads are an additional and often overlooked expense, and investors can magnify their impact by trading frequently.

Buy-and-Hold Is Best
Brokerage fees also arguably discourage investors who otherwise would have traded rapidly in pursuit of hot performance, which is almost always a ruinous strategy. Based on studies of asset-weighted returns of funds and ETFs, most people who chase performance end up buying high and selling low and reducing their returns. They also could end up paying a lot in taxes as they generate short-term capital gains, which Uncle Sam nicks at a higher rate. Vanguard hopes to control traders by reserving the right to restrict ETF trading if an investor makes more than 25 trades in the same fund in 12 months.

Clearly, Vanguard investors have to be careful with this newfound flexibility. Morningstar's ETF analysts offer many sound suggestions for using ETFs opportunistically and tactically. My own personal philosophy is to keep things simple. Legendary Ohio State football coach Woody Hayes used to explain his aversion to passing by noting that three things could happen when you throw the football, and two of them are bad. I feel the same way about ETFs. You can do a lot with them�trade, short-sell, buy on margin, use stop-loss and limit orders, and buy and write options. But that doesn't mean you should, or that the additional flexibility makes you a better investor.

There are simple, long-term-focused ways to take advantage of Vanguard's new policy. ETFs are hard to beat if you plan to plunk down a lump sum in a few broadly diversified index funds and leave it there for years to let the funds' low costs and tax efficiency work their magic over time. Vanguard Total Stock Market ETF, FTSE All-World ex-US ETF, Total Bond Market ETF, and Vanguard Total World Stock ETF (VT) are all viable building blocks for such a strategy.

Our Complements
You also could use ETFs to complement an existing portfolio. For instance, if you work in a particular industry and own a lot of your employer's stock, you can use Vanguard's sector ETFs to get exposure to other areas of the market.

Maybe you work in the health-care field. You've used your familiarity with the area to build a portfolio of stocks in that sector; but you want more variety, and you aren't comfortable picking stocks in other sectors. You could use sector ETFs such as  Vanguard Industrials ETF (VIS),  Vanguard Information Technology ETF (VGT), and  Vanguard Consumer Discretionary ETF (VCR), and others to round out your holdings.

Perhaps you already have a well-rounded portfolio, but you want to emphasize a particular part of the market. This is often referred to as the core-and-explore approach. You keep most of your money in solid, cheap, broadly diversified stock and bond funds and use a small portion of your kitty, say 5%-10%, to invest opportunistically. For instance, maybe you think the valuations of high-quality, dividend-paying stocks currently look attractive (I do). If you want to tilt your portfolio toward such stocks,  Vanguard Dividend Appreciation ETF (VIG) is a fine candidate. It's full of solid, competitively advantaged companies that have long histories of raising their dividends.

Buy the Unloved
If you are going to use the core-and-explore approach, it could pay to be a contrarian. The wide range of Vanguard's style- and sector-specific ETFs makes them perfect tools to implement Morningstar's Buy the Unloved strategy.

The premise is simple. It's based on the belief that you can make money by buying the funds what everyone else is selling. My colleague, Director of Fund Research Russel Kinnel, has followed the strategy for years and recently described how it works and its record here. In sum it involves buying at the start of the year funds from the three most heavily redeemed categories of the previous 12 months and holding them for at least three years. At the beginning of 2010 the unloved categories were large-cap growth, large-cap value, and world stock. The loved categories were diversified emerging markets, foreign large blend, and Pacific/Asia ex-Japan. It's simple to implement this strategy with Vanguard ETFs. Just use  Vanguard Growth ETF (VUG),  Vanguard Value ETF (VTV), and Vanguard Total World Stock ETF. Other options include Vanguard High Dividend Yield ETF (VYM), or Vanguard Mega Cap 300 Growth ETF (MGK) or Mega Cap 300 Value ETF (MGV).

Rules of the Road
For the best results, though, follow a few rules:

1. Buy one fund from each category. Betting everything on one unpopular category can be risky. Not every unloved category will catch fire, and one group can pull the weight for the entire trio.
2. Be patient. Be prepared to hang on for three (or five) years, even if it takes awhile for the unpopular categories to turn around.
3. Use a tax-sheltered account. This strategy requires less turnover than the average mutual fund; however, it could expose you to taxable capital gains if your funds turn into winners.
4. Some ETF strategies can be higher-maintenance approaches, but if implemented with care and attention, they can make good use of the Vanguard's new, more liberal ETF brokerage policy and expanded ETF lineup.

A version of this article appeared in a previous edition of the Vanguard Fund Family Report.

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