Exchange Traded Funds (ETFs) are a terrific vehicle for investors, offering an easy way to build diversified portfolios that are transparent, tax efficient, and low cost. We’ve written frequently about the advantages of ETFs and hold them as core positions within all of our portfolios.
This week, our custodian, TD Ameritrade, announced that it was expanding its platform of commission-free ETFs from 100 to nearly 300 funds. Wonderful, right? Not so fast… while the total number of ETFs will increase, they are actually dropping 84 low-cost ETFs, including ALL of the Vanguard ETFs we use for each and every client.
To say that we are disappointed and frustrated is an understatement. We are big fans of Vanguard and have used these funds since we opened three years ago. They are among our largest holdings. Why is TD Ameritrade dropping these funds? Distribution fees. Vanguard does not pay custodians to distribute their funds, but other companies will pay TD Ameritrade to be on their commission-free platform.
As a whole, the changes to the TD Ameritrade platform are appalling to me. We lose low cost ETFs from Vanguard and the iShares Core series, and instead are offered mainly niche ETFs with high expense ratios. Many of the new ETFs are focused on a very narrow area such as the “nasdaq smartphone index” or the “dynamic pharmaceuticals” ETF. This approach is antithetical to our process of diversification. Sometimes being given more options does not mean that you have better choices.
There is one bright spot: they are adding the new SPDR Portfolio Series from State Street. State Street is one of the three largest ETF providers, along with Vanguard and iShares, and is the creator of the original S&P 500 ETF, SPY, which launched the whole ETF movement nearly 20 years ago.
In recent years, State Street has been struggling to keep up with lower cost competition from Vanguard, Schwab, iShares and others. The new Portfolio Series took a handful of their most diversified ETFs, many with track records of over 10 years, and slashed the expense ratios to levels at or below even Vanguard. These will be our new go-to funds.
We can of course, continue to buy and sell the Vanguard ETFs through TD Ameritrade. However, after November 16, those trades will incur a standard commission (as low as $6.95). And that is still a bargain. Should we drop our Vanguard funds in the next month, while they still trade for commission-free?
Here is our plan:
1. In taxable accounts, we may have significant capital gains in our Vanguard positions. It does not make sense to realize thousands of dollars in gains just to avoid a $6.95 commission. (If we had losses, we would harvest those losses, but the market is up nicely this year. I’m not complaining!)
2. Even when there is zero commission, there are still trading costs. Just like stocks, ETFs trade in an auction process where buyers offer a “bid” and sellers request an “ask” price. The Vanguard ETFs are heavily traded, sometimes with multiple trades in one second. The difference between the bid and ask price, the “spread”, is often only one cent.
However, on ETFs that trade less frequently, the spread can be much higher. I looked at a small-cap value ETF this week that had a 14 cent spread. So, even in non-taxable accounts like IRAs, there may still be a hidden cost if we were to sell Vanguard to buy the SPDRs. As trading volume increases, I anticipate bid-ask spreads will tighten on the newly added funds. But for larger positions, selling one ETF at the bid and buying another at the ask could certainly cost more than the $6.95 commission we are trying to avoid.
3. For new purchases, we will use the SPDR Portfolio Series, effective immediately. They trade commission-free and in many cases have a lower expense ratio than a comparable Vanguard Fund. Existing portfolios will continue to hold Vanguard Funds. This means that many portfolios will unfortunately now have some duplication, where for example, we might own a Vanguard International ETF and also own a similar SPDR International ETF. I try to avoid that sort of redundancy, but it does not really cause any harm.
4. In IRAs with smaller positions, we will look to sell Vanguard within the next few weeks and replace those positions with a new commission-free option. We will still be needing to rebalance portfolios annually, in which case, it is nice to be able to do so commission-free. These trades will be done on a case-by-case basis.
Please feel free to email or call me with any questions. This change at TD Ameritrade has created some temporary hassle, and received quite negative press on Wealth Management.com and in a scathing piece by Michael Kitces.
This change isn’t going to detract from our approach or impact our investment process. We start with a top down asset allocation and then choose the best fund to fulfill each segment of our allocation. We certainly don’t limit our search for investments to just commission-free ETFs, and have always also had mutual funds or ETFs that are not on the commission-free platform. As your Fiduciary, we take seriously our responsibility to keep fees as low as possible, but it’s not true that the lowest cost is always the best investment option.