Archives for June 2010

I ran across another cautionary tale highlighting the world of paid stock newsletters, where people pay hundreds of dollars for “exclusive” stock picks.

In this one, former professional baseball player Lenny Dykstra somehow become a highly-touted investment columnist in 2005 for TheStreet.com. Here’s a video of Jim Cramer heaping praise upon Dykstra, calling him “one of the great ones” and one of the 5 people in the world he’d take stock advice from.

Dykstra specialized in deep-in-the-money calls, and promised a 95% success rate. He sold over a million dollars in newsletter subscription fees at TheStreet.com. Then things started falling apart.

Sharp bloggers exposed this scam: he counted his winners, but endlessly rolled over his losers, so that he could keep claiming no losses. He didn’t even make the picks himself; they were supplied by another stock analyst. His actual return on money was probably negative. Dykstra was fired in April 2009 and is now in bankruptcy.

The most recent allegation is that Dykstra secretly took $250,000 in exchange for recommending a little-known stock to his newsletter subscribers and “access” to Jim Cramer, according to sources within the company.

As you can see, stock newsletters can be very murky. How can you verify their advertised performance is true? Are they being paid to tout the stocks you’re reading about? Mutual funds are highly regulated. Stock newsletters are not.

Most stock newsletters are more about marketing than actual results. For example, did Cramer really think Dykstra was a genius? Or did he simply see the opportunity to leverage an athlete’s well-known name to create a lot of easy buzz and thus money?

The bottom line for converting to the ETF version of equivalent mutual funds: lower costs = greater returns = more money. To illustrate this, I ran over to Mornginstar.com and compared the 5-year returns for VEIEX and VWO, the mutual fund and ETF versions of the Vanguard Emerging Markets Index Fund, respectively. Here’s the growth chart of $10,000 invested from 6/24/2005 to 6/24/2010 (click to enlarge):

Looks pretty much the same, right? That’s because they hold the same stocks inside, but VWO has a lower cost through its lower annual expense ratio. That initial $10,000 would have ended up as $18,086.98 invested in VEIEX, while it would have become $18,374.63 invested in VWO – a difference of $287.65. Not a huge difference, but significant in my book, considering it required no increase in risk.

This comparison also doesn’t take into the additional 0.5% purchase fees and 0.25% redemption fees charged by VEIEX when buying and selling shares, although the hit does become less significant as your holding period lengthens.

You want index funds. You want Vanguard. Should you buy them in mutual fund form, or ETF form?

There are several pages on the Vanguard website dedicated to help you learn the differences between their ETFs and mutual funds. Check out their ETF basics page and their ETF vs. mutual funds page. There is a nice little video if you visit this page and look for this image:

Briefly, Vanguard mutual funds have different share classes. For their popular index funds, there is usually an Investor class of mutual fund, an ETF class, and an Admiral class for $100k+ balances. For example, for the Vanguard Total Stock Market funds, you have VTSMX (investor), VTSAX (admiral), and VTI (ETF). Each share class still holds the same basket of stocks. How they differ is primarily in trading structure, and both transaction and ongoing costs.

Reasons to Switch to ETFs

• ETFs generally have lower expense ratios. This mean each year, all else equal, your net returns will be higher with the ETF than with the mutual fund. Over a long period of time, this savings can be substantial.
• Greater trading flexibility. ETFs trade on an exchange alongside individual stocks, which means continuous intra-day pricing, and the ability to use advanced orders like limit or stop orders. (If you really want, you can even buy them on margin and/or short sell them.) Mutual funds are only traded at one price a day, and only with market orders.
• No short-term redemption or other sell fees. This only applies to certain mutual funds.

Why You Should Stick With Mutual Funds

• No automatic, dollar-based trading. If you like to dollar-cost-average, for example by automatically investing a regular amount of $100 every two weeks, then you would have to stick with a mutual fund.
• Smaller balances. You need a $3,000 minimum to open a Vanguard Brokerage account. Also, if you have only say $2,000 in an IRA, you will be left with some uninvested cash because you must buy whole shares.
• Bid/ask spread. This is a small transaction cost that represents the difference the offer and the sale price on an exchange, and ends up being profit for the market-maker. Vanguard provides estimates for the effect of this spread in their ETF calculator (see below).
• Commission costs. This is not a concern in a Vanguard Brokerage account as they allow Vanguard ETFs to be traded commission-free, but in other brokerages they will charge their standard commission fees.
• NAV premium/discounts. An ETF is allowed to trade above or below the actual value of the assets taken separately (NAV, or net asset value). Usually market forces and arbitrageurs keep such deviations from being large, and if you buy regular amounts it should even out over time, but at times the premiums can be significant. Some investors don’t like this uncertainty, and prefer the knowledge that they every purchase exactly at NAV.

Vanguard even created a nice mutual fund vs. ETF cost comparison calculator where you can punch in your number and see the long-term expected savings of buying ETFs. It takes into account bid/ask spreads, commission costs, future purchases, and more.