Most investors and mutual funds fail to beat the market averages. This is because — unlike numerical market averages — investors and mutual funds have to pay transaction costs and taxes.

Study after study confirms that the prudent way to outdo at least 80% of your friends and neighbors over the long run, when it comes to their stock market results, is not to try to beat the averages but simply to minimize transaction costs and taxes. This you can do in a number of ways, two of the most popular of which are: index funds (mutual funds which merely try to match the averages, not beat them) and spiders (which trade on the American Stock Exchange like stocks but are actually “unit trusts” designed to mimic the Standard & Poor’s 500 — symbol: SPY).

I’m frequently asked “which is better,” index funds or SPDRs, and up until now my answer has been: “It’s basically six of one, half a dozen of the other — go with whichever is more convenient if you’ve decided to go for an S&P 500 surrogate.”

(There are other indexes you might try to match, as well, or instead, using other index funds or spider-like derivatives.)

Thanks to my brilliant Ohio State finance professor friend Spencer Martin (who at 19 was one of the key developers of Managing Your Money software), I now realize there’s a bit more to think about here.

Spencer writes: “My research so far indicates that, given broad availability of deep discount brokers, SPDRs are clearly dominant in every relevant dimension, and the index funds should be out of business except for captive audiences like 401k plans and such.”

That may be a little extreme. Index fund investors: don’t be alarmed, you’ve still done a smart thing. But hear Spencer out:

1. Expenses. SPDRs charge 18 basis points a year — 18 hundredths of 1%. Fidelity and Vanguard charge the same, at the moment, but ONLY by temporarily waiving fees from their natural level of 27bp per year. That’s a one-third difference in expense levels (in your parlance, a truly skeletal “jockey” rather than a merely anorexic one). Furthermore, as shown in a recent WSJ article 5-21-99, most open-end index funds are considerably more expensive (even all they way up to 144bp — they ought to be in prison!). Ultimately, the SPDR will win this dimension since they don’t need any telephone banks to provide customer service etc, and in the long run even Vanguard and Fidelity do.”

Hmmm. My guess is that for competitive reasons, the low-cost index funds will keep their rates low forever. It’s true that, once invested for a few years, a fund owner is a little stuck. Tax would be due on any gains if he sold to switch to a cheaper fund. So he is sort of a captive audience. But that’s only true of taxable accounts. A great deal of the indexed money is held within tax-sheltered retirement accounts, where switching to a cheaper alternative would be easy — and thus keep a competitive lid on pricing.

I suppose a fund might one day try raising annual expense charges to milk extra profit from captive investors, while offering a “discounted rate” to retirement plan money, to keep it from fleeing. That would be pretty nasty — and might or might not hold up if challenged.

And even if the annual fee did jump from 18 to 27 basis points, how much difference do nine basis points make anyway? Not much, relatively speaking. (Invest $2,000 a year for 40 years at 8% and you end up with $561,562. At 8.09%: $575,466. A tad more, to be sure, but not earthshaking — especially as the rate hike might well not happen.) Still, Spencer definitely has a point.

2. Liquidity I. SPDRs can be bought or sold throughout the day rather than an open-end funds’ fixed mark-to-market time. The cheaper open-end funds severely restrict the number of transactions you can make too.”

Of course, as any day-trader with an automatic weapon can tell you, trying to time the market’s peaks and troughs throughout the day is not so easy. And trading in-and-out only racks up transaction costs and taxes. So for prudent investors, this barely matters.

3. Liquidity II. Because SPDRs are not redeemable for cash, the manager does not have to worry about distortions due to sudden rushes of money in or out, particularly out. If enough people want out of an open-end fund, that forces sales of assets, which depresses Net Asset Value.”

Well, the prudent investor will be selling not when everyone else suddenly is, in a panic (rarely a good time). And even if he does, the price of the SPDR will more or less reflect the same carnage.

4. Taxes. Due to the Unit-Trust construction, SPDRs generate considerably fewer trades, and hence passed-through taxes, than even the best managed open-end index funds.”

Again, the difference will be slight. Index funds tend not to have to do much selling at all. They sell when one stock in the index is replaced by another or when outflows from the fund exceed inflows. But in the latter case, the selling is done by selling the highest-priced tax lots first, on which the fund is likely to realize a loss, not a gain. (You’ve heard of FIFO and LIFO? First-in-first-out and last-in-first-out? This is HIFO — highest-in-first-out.) Only if huge numbers of shareholders redeemed their money might this become an issue — and probably not even then, because in such an environment, prices would be so low, losses might more than balance gains.

(Vanguard estimated not long ago that, because of HIFO accounting, if the market fell 20%, fully 38% of its shareholders would have to cash in their chips before net taxable gains even began to appear, let alone became oppressive. If the market fell 50% or 80%, the redemption level would obviously have to be even more extreme, as fewer and fewer of the fund’s positions would be in the black the lower the prices fell. But massive redemptions are unlikely in any event. Index fund investors tend not to be all that flappable. During the period of the 1987 market crash, Vanguard’s flagship index fund experienced a modest 6% net redemption.)

OK, one might fairly ask — but what about decades from now, when baby boomers are deep into their nursing homes and withdrawing money like crazy? By then the unrealized gains in index funds may have become all the more huge — what about then? Isn’t this a ticking time bomb for the shareholders who remain?

Probably not. The investment road doesn’t stop. (When I was first learning to drive, I would slow to a crawl as I neared the top of each hill in case the road just stopped on the other side.) If the market is at decent levels decades from now, it will be because new, younger investors have been investing — some of them, no doubt, through index funds, taking the place of the shareholders looking to get out.

This is not to say there might never be appreciable, taxable capital gains distributions from a well-managed index fund. But I don’t see it as a big problem.

5. Flexibility. The brave can short SPDRs, with no uptick rule even. Try that with an open-end fund.”

Well, don’t try it with either. But again, while this is true, and a useful point for the billion-dollar hedge-fund manager, it has little relevance for the prudent individual investor.

6. Tracking. The SPDR is going to be best at tracking the index. Now, granted Vanguard and Fidelity will do fine at this, but read the fine print of the other entrants — they don’t promise to hold all 500 stocks, which means their tracking ability will only be as good as their managers can manage. The price of the SPDR is kept to 1/10 the index value by very strong arbitrage forces. Any divergence would trigger creations [of new SPDRs] or redemptions [of old ones].”

One more good reason to stick with Vanguard or Fidelity.

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All six points turn out to be of somewhat marginal importance for the average investor, in my view. But they make you think.

Then again, consider a couple of equally small points on the other side:

  1. You pay no brokerage commission to buy or redeem shares in an index fund. Buying or selling SPDRs and the like you would — although at a deep discount broker the cost will be all but insignificant.
  1. SPDRs accumulate dividends and reinvest them once per quarter. Index funds that reinvest dividends as they are received thus get a small edge from what is, in effect, “daily” as opposed to “quarterly” compounding.

So I guess in my mind it remains, for most people, largely six of one, half a dozen of the other. Go with whichever one is most convenient.

 

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