Wage Garnishments

Posted on May 13, 2008
Filed Under Personal Finances |

By Selwyn Gerber:

“I love index funds and ETFs. Index funds and ETFs are inexpensive to buy and own. They afford you immediate diversification, and they’re extremely tax-efficient investments. Their performance is terrific and you aren’t paying exorbitant fees to a fund manager. They’re also very stable, meaning you don’t have to worry about any unexpected changes a manager might make, or worry about the impact of a management change, or worry about winding up overexposed to any particular market sector.”
- Economist Ben Stein

Payroll tax

ETFs are able to accept shares from very large investors, like pension funds, and this allows them to lower the costs of acquiring shares when compared to index funds. Similarly, they can give shares to very large shareholders looking to close their positions. Overall, this lowers costs only slightly, but helps with tax efficiency. By not actually selling or buying shares, they are not creating capital gains. Small savings in costs and taxes can add up to large gains over the long-term. Therefore, this process favors ETFs.

Tax savings

To meet redemption requests, index funds need to maintain a certain level of cash among their assets. In a rising market, holding cash lowers returns compared to being fully invested. This is not an issue with ETFs because they can instantly raise cash through selling stocks, selling futures or options contracts, or borrowing from an investment bank for a short time.

Tax saving

Other costs, such as management fees and taxation, also favor ETFs. Management fees are generally lower for ETFs because they are not required to maintain individual records on each shareholder like mutual funds are required to. The brokerage company you invest with incurs these costs for ETF holders and builds them into the cost of commissions. Index funds need to spend a great deal of shareholder money complying with reporting requirements.

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While shareholders can usually buy or sell index funds at no cost, this is not the case for ETFs. Buying an ETF requires paying a commission to a broker. Using an online broker, this will probably be $5 or $10 – about 0.1% of a $10,000 investment, and a lot less on a percentage basis for larger investments. This is much less than the difference in management fees, and is a small price pay to pay in order to obtain those savings. In general ETF’s are suitable for those who wish to buy-and-hold because the upfront commissions can be amortized over a long holding period, while mutual funds may be a good way for those who tend to hold for shorter periods because there is generally no entrance or exit fee for no-load mutual funds.

In “Index Mutual Funds and Exchange-Traded Funds,” Leonard Kostovetsky attempts to objectively quantify the differences between ETFs and index funds. According to his analysis, with a longer-term time horizon of at least 10 years, an investor with at least $13,000 is better served by being in ETFs, and the larger the amount invested, the shorter that break-even period.

A final advantage of ETFs is that you can take advantage of the many options available to develop the right asset allocation strategy for your financial circumstances. There are more options available through ETFs to match the multiple lifestyles that individual investors face. You can design a portfolio with ETFs to achieve a value or growth tilt, overemphasize small cap or large cap investments, and attain the desired amount of global stock market exposure. This process ensures exactly the right balance of risk and reward to match your needs.

Chapter 7: THERE’S A HOLE IN THE BUCKET: WHY ACTIVE INVESTORS GET LOUSY RETURNS

Most investors don’t realize how multiple layers of fees and tax inefficiency eat away at their portfolio returns. Active managers pursue gains without consideration of the best interests of their investors.

“If you pay the executives at Sarah Lee more, it doesn’t make the cheesecake less good. But with mutual funds, it comes directly out of the batter.”
- Don Phillips, President, Morningstar

Mutual funds are managed by some of the best and brightest minds on Wall Street. The managers have the best of intentions and are sincerely motivated to deliver the best returns possible. Unfortunately, not all of them can be better than average and most can not even overcome the handicap imposed by high cost structures to match the market.

When discussing the virtues of mutual fund investing, your investment advisor is very likely to bring up the miracle of compounding. You will be shown the value of investing for the long-term and how important it is to let you money work for you. These points have been illustrated in this book as well. However, most investment advisors leave out the rest of the story – what John Bogle refers to as the ‘tyranny of compounding costs’ which means that fees and taxes accumulated over long periods significantly reduce your wealth.

One seemingly small cost is the amount managers spend to but and sell the thousands of shares of stocks they trade every day. These transaction costs add up over time. We all know from television and newspaper ads that stock commissions amount to only pennies a share. Mutual funds buy and sell a lot of shares and those pennies add up. While each transaction cost seems insignificant by itself, over time, they detract from the performance of the fund.

Wage Garnishments

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