It’s hard to consistently beat the market as an investor…but it takes zero effort to match the market.
Picking good index funds lets you match the market for near-zero cost.
And matching the market produces some pretty good results. If you had invested – and held – $100k (and not a dime more) in a plain vanilla S&P 500 index fund in January 1990, today it would be worth over $1M.
That’s 10x growth in 3 decades, or +7.7% annualized returns.
That’s despite a 1990 recession, 2000-2002 dot com bust, 2008 financial crisis, and 2020 coronavirus.
And all for zero effort.
I dunno about you, but index fund investing sounds richer and a lot more laid back than active stock picking (which almost uniformly results in lower returns anyway).
The key is picking good funds. What’s the best way to do this?
This week, I talk with Jonathan Duong, CFA, founder of Wealth Engineers, a wealth management consultancy, about how to pick the best index funds to invest in.
- Key differences between mutual funds vs. ETFs; between tracking, passive, and active funds
- Step-by-step tips for evaluating an index fund: attributes, criteria, performance indicators
- Recommended online tools to search for and filter indexes and fund options
- How fund expense ratios work
- Specific names (and ticker symbols) of popular index funds for: total stock market, total bond market, government bonds, real estate, all-weather portfolio
What are your favorite index funds, and why? Let me know by leaving a comment.
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Links mentioned in this episode:
- Wealth Engineers
- ETF Replay
- The CRSP Indexes
- US total stock market: VTI, ITOT, DFQTX, DFTCX
- International stocks: VXUS, IXUS, VEA, VWO, IDV, IEMG
- Value-focused stocks: VTV, VBR, IJS
- US investment grade bonds: BND, BSV, BIV
- US government and municipal bonds: VGSH, VGIT, SPTI, MUB, VTEB
- International investment grade bonds: BNDX, DFGBX, DWFIX
- Real estate: VNQ, VNQI, DFREX, DFITX
- Total market / all weather portfolio: target date funds (various), Vanguard LifeStrategy
- Schedule a private 1:1 consultation with me
- HYW private Facebook community
Read this episode as a post:
Andrew Chen 01:23
My guest today is Jonathan Duong.
Jonathan is the President of Wealth Engineers, a Denver-based fee-only financial planning and wealth management consultancy that is focused on low cost asset management.
He previously served as the director of investments for another Denver-based wealth management firm. And he also worked in Ernst & Young’s Transaction Advisory Services group, where he focused on advising corporate and high net worth clients on investment, tax, and planning issues.
Jonathan holds the CFA and CFP designations, and I invited him to the podcast today to share insights about index fund evaluation and index fund investing.
Jonathan, thanks so much for joining us today to share insights and tips all about index funds!
Jonathan Duong 02:01
Yeah, absolutely. Thank you for having me. Looking forward to the discussion, for sure.
Andrew Chen 02:05
I’d love to start out just by understanding a little bit more about your background.
How did you get into financial planning, and in particular, the type of financial planning that you do or specialize in? What makes your approach different?
Jonathan Duong 02:18
My history really goes back to two inspirations. I think in general, my family bloodline is very entrepreneurial. Most of my dad’s side of the family, they own their own businesses, started their own businesses, always really been focused on thinking through strategically how to build the life that they want.
So there’s an entrepreneurial mindset, an “If you want it, you can have it, as long as you put in the time and effort” type of mindset. That really, for me, always meant I’m always looking to figure out ways to get more from less, figure out how to squeeze more juice in the orange, so to speak.
I think that’s what set me on the path largely towards business and towards finance in general.
And then I really had the opportunity, and I’m very grateful, for undergraduate coursework that I took, particularly under a couple of professors at my alma mater, Cal Poly. One in particular, I studied under a professor named Professor Larry Gorman, and in our Business 431 class, if memory serves correctly, I actually got exposure as an undergrad to the Fama-French three-factor model.
Some of your audience members may know a pretty famous research by Eugene Fama and Ken French, basically looking to improve upon the way that stock returns can be analyzed or explained beyond just a market beta or a single-factor model into a multifactor model, in this case, in addition to market beta, also looking at size or the small cap risk premium as well as the value risk premium or the relative price premium.
Long story short, I just got exposure to that when I was an undergrad, and it just clicked. It’s like, “This makes a lot of sense.”
And then after that, the rest is history. I was just hooked, completely interested in how to invest, how to think about investing, how to manage money.
After that, it was just one step after another, from the CFA to the CFP. A lot of story in between, but that’s the foundation and the framework.
Andrew Chen 04:20
What makes your approach different in your practice?
Jonathan Duong 04:25
Just briefly high level, the three things that we really focus on, the reason clients ultimately come to us, I believe, one is a more integrated approach that understands how all of the different components of an individual’s personal financial situation fit together.
I use a lot of lip service that gets paid to holistic wealth management or comprehensive wealth management. And it’s a catchphrase that gets thrown around a little bit too easily without a whole lot of thought.
But for our approach, that means a lot. That, for us, means really understanding the tax implications of the decisions that we’re making in real time.
Whereas a lot of times, a client is not really thinking about tax issues until April, we’re looking at those throughout the year and figuring out, “Are there things that we can do, either from a capital gains perspective or a Roth conversion perspective or thinking about Medicare premiums?”
“How do all these things fit together from a tax perspective? Can we optimize or strategically plan during the year so that, come April, the client’s situation is a lot better?”
Because as we all know, most tax-related things, you can’t wait until April. There’s a few you can still make an IRA contribution or a Roth contribution. Most of the things have to be done between January 1 and December 31st.
So it’s really an integrated tax mindset and thinking through holistically how all of these things fit together from a tax perspective, looking at risk and insurance, thinking about estate planning, in addition to all the other things that you would think about with traditional financial planning. So I’d say that’s one.
Second, about a quarter of our clients are business owners or are very directly connected in terms of a partnership or equity stake with their business, and coming from a background of a lot of corporate finance experience and really understanding valuation, how businesses are valued, how they grow, how they transact.
A lot of those types of things tend to be an area of differentiation where we can have really deep, really meaningful conversations with business owners to help them prepare for something like a liquidity event and selling their business as they approach retirement. I think that’s another big factor.
And then, of course, it all comes back to a focus on cost efficiency, tax efficiency, transparency, putting a client first. You put all three of those things together, and that’s really how the business is grown and I think why most of our clients come to us.
Andrew Chen 06:49
That’s really helpful to keep in mind. Let’s talk a little bit about index fund selection.
Most people in my audience will know at a high level what an index fund is, i.e., that it represents a basket or a collection of individual securities that you can buy as a single investment to get exposure to all the securities in the basket at once – whether you’re doing that for diversification purposes, or low cost, or to bet on a certain investment thesis, whatever the case may be.
But they tend to come in a couple of different flavors. There’s mutual funds. There’s ETFs.
What are the key differences first, to start, between these two types? Things like timing of trades, volatility, tax efficiency, fees. Does one tend to be better than the other for retail investors, in your view?
Jonathan Duong 07:35
Let me just start by saying the obvious from a compliance perspective, being that my firm is a registered investment advisor and I am an investment advisor representative of that firm.
Obviously, none of what we’re talking about here is specific investment advice. You should certainly complete your own diligence, consider your own financial situation, consult a financial tax or a legal professional, and so on and so forth.
With that said, most of the time, we’re thinking about an index-oriented investment. I think historically, people think index fund, they think of the mutual fund or the open-end mutual fund structure. That’s where all of this started.
But as we all know, the advent of the ETF structure has really taken off, so you have this huge influx of choices that are now available, most of them coming out in ETF form.
So, as far as the differences go, there are some obvious. Most of your listeners probably know intraday trading, where an ETF, you can trade at any point in time during the day, whereas a mutual fund is always going to trade one time per day, at the end of the day, closing value.
What that really means is if you are an active trader, if you’re somebody who is trying to implement a tactical strategy, obviously, an ETF structure can be more favorable. If you’re a long term investor, I’ll be honest, most of the things that we’re going to unpack here in a second don’t really matter that much, as long as it’s a well-designed open-end mutual fund.
There are other differences there that we need to be mindful of. Cost is a pretty large umbrella here, and there’s a lot of things underneath that.
Certainly, in general, the ETF structure tends to be more cost-efficient in that it’s typically cheaper. Not always, but in many cases, you’re going to save a basis point or a few basis points on the expense ratio with an ETF structure. That’s certainly one consideration.
Second consideration is, all else equal, ETFs are usually more tax-efficient. But I don’t think that’s always the case. I think that’s an oversell in some cases.
A lot of times, if we look at a well-designed open-end mutual fund compared to an ETF, let’s say from Vanguard or some of the other options, say for Vanguard specifically, the ETF in the open-end mutual fund, they’re exactly one and the same. It’s just a different share class of exactly the same fund, so you’re going to have a lot less differences in that type of structure.
In other cases, you can make the argument in favor of the ETF.
Beyond that, other things I think every investor needs to look at: bid-ask spreads, where if you have a thinly traded ETF where, let’s say, it’s either in an asset class, in an area of the market that just doesn’t have as much liquidity, or if that given ETF just doesn’t have a whole lot of market shares (it’s fairly small), you can end up with a situation where you have a substantial bid-ask spread.
Basically what that means (your listeners probably know), the bid and the ask represents what is the market maker or the other party you’re trading with willing to buy that share of that ETF for, and what are they willing to sell it for?
The difference between that represents the spread. And the wider that spread is, the larger the cost for the investor. So that’s certainly another consideration as well.
Outside of that, I’ll be honest, as long as you’re choosing a well-designed open-end mutual fund and a well-designed transparent ETF, the differences are a lot fewer than they are. They’re not nearly as significant as sometimes they’re made out to be.
Andrew Chen 11:09
You’ve used this term a few times now: well-designed open-end mutual fund, well-designed ETF. Can you explain what makes such a fund, both on the ETF side and the mutual fund side, well-designed?
Jonathan Duong 11:22
There’s several things that I look at in terms of evaluating. When I go through and I look at my due diligence spreadsheet, which I have up on my screen right now and I’m looking at, there’s many different factors.
Of course, I’d say the single most important thing above all else is what index or benchmark are we actually tracking here? You’ll hear all the time people just throw out the term “index fund” as though that actually means something in and of itself.
Well, we can have an index fund that tracks the S&P 500, U.S. large cap stocks. We can have another index fund that tracks emerging market stocks or real estate or so on and so forth. There are many different asset classes.
We have to understand which benchmark, which index we are actually seeking to track. That’s probably the single most important.
And all else equal, in most cases, first and foremost, I’m looking at the index, and then going out and finding the funds that are tracking that index, not the other way around.
I’m a big believer, and I encourage all of our clients to adopt this mentality, this mindset. And I encourage everybody who is even not a client of ours just to think through this philosophy, which is, “strategy first, product second.”
If you are talking to somebody who is starting with product first, i.e., “You have to be in this fund,” usually that’s a pretty good indicator that maybe that’s not the right solution.
You really have to start with strategy first. What strategy are you trying to implement? And then you go to the marketplace and find the best funds that fulfill that solution.
So, certainly we need to look at the benchmark or the index. We need to look at whether it is truly an index fund or whether it’s passively managed but tracking that benchmark, or whether it’s in this increasing bucket that’s now available in ETF form, which is a semi-transparent or non-transparent, actively managed type of solution but is inside of an ETF structure.
And those are three very different things that investors need to be acutely aware of.
Andrew Chen 13:19
Can you comment a little bit more about the differences between those: a classic index fund, a passively managed but tracking the index, and an actively managed? How should investors think about what are the variances between these?
Jonathan Duong 13:37
I think the easiest way to wrap your head around this is a classic index fund, say something from Vanguard or iShares or SPDR or any of the other fund families, what they’re doing is they’re licensing a commercial index.
So the index itself is not investible. It’s largely a performance tracking or a benchmark tool for a certain set of securities. It’s not actually directly investible.
But the fund family is licensing that index, and they’re paying a fee to do that. And then the objective of the mutual fund manager (if it’s an index mutual fund) or an ETF manager, is they want to try to track that index as closely as they possibly can, less the fees that they charge.
Of course, that means that a mandate of a well-designed true commercial index fund is to minimize what we call tracking error, the deviation from the index performance relative to the fund performance.
That’s your typical commercial index fund, the most famous, of course, being the S&P 500 index. So if you are a fund manager, you want to license the use of the commercial index, the S&P 500, then your goal becomes to track that particular index.
The second bucket, passively managed but not strictly index funds, probably the most famous here is going to be a fund family that many of your listeners may know, which is DFA, or Dimensional Fund Advisors.
DFA uses a passive strategy. It’s a rules-based strategy.
And they have benchmarks for each fund, of course, just like any other mutual fund does, but they’re not strictly trying to track the index necessarily because it’s not an index fund. It’s a passively managed, rules-based fund.
So the difference being it’s not the manager simply saying, “Well, I think it’s time to get in or out of the market” or “I think Apple is poised to take off, but I think Microsoft is not going to do as well.” Just naming names here, not any specific prognostication, of course.
They’re not doing that. Rather, they’re defining a certain set of rules, and they’re implementing those rules in a systematic way. And that ultimately makes it passive.
It’s not strictly an index, but it’s passive. It’s not active in the sense of what we would call a tactical type fund.
And then, of course, the third bucket, like we talked about, that historically has been the actively managed mutual fund and now is coming in other flavors and forms, like semi-transparent or non-transparent ETFs, where the manager is actually trying to outperform through security selection or market timing or other things like that.
Because of that, you’re not just simply accepting the passive structure or the index. You’re actually trying to outperform the benchmark. And there are an increasing number of funds that fit within this bucket, but that are not the classic actively managed open end mutual fund that are now in the ETF structure.
Andrew Chen 16:32
You mentioned that the really right way to do this is strategy first, product second. So, first, analyze what is the index.
And I was curious. How can people search for what the available index options are, so that they don’t go straight to fund, but they first think more broadly about what index suits their investment philosophy and risk profile? How can they even go and search and find what the list of index options even are?
Jonathan Duong 17:12
Certainly I’ll throw in my recommendation that it all starts with financial planning. Even before we get to a point of designing a portfolio, I think it all starts with an investor’s financial plan.
You really have to think about what portfolio, what asset allocation, do you actually need in order to fulfill your goals? Because there’s no single right answer, and just your age, as an example, is not a sufficient indicator of that.
Once that’s been established, then I think you can start this a couple of different ways. The most typical, I’d say, would be use a site like Morningstar or etf.com or ETF Database or one of the other platforms that are available that allow you to do side-by-side comparison of various funds. That’s certainly one approach.
And all else equal, if you already know you’re going to stay within the Vanguard, iShares, SPDR world, that’s probably the easiest thing to do is just to be able to simply go up to one of these websites and make some comparisons with the underlying characteristics of those ETFs or funds.
For those who are more nuanced, more want to understand the nitty-gritty, then that’s where you could go directly to one of the commercial index licensers’ websites. You could go to MSCI.
You could go to CRSP. CRSP is the Center for Research and Securities Prices. That’s what Vanguard increasingly uses for many of their funds.
Of course, another being Standard & Poor’s or Dow Jones.
You could go to these particular websites, and they will publish the specifics of how they define that index, what that index consists of, how many companies are in the index, which countries, if it’s a stock-based index, is it a growth index, how do they define that? They’ll publish all of this information.
If you really want to dig into that, you can. And then work backwards from there and say, “Now that I know which index I want to focus on (say the Russell 3000 or the S&P 500 or the ACWI or something like that),” and then say, “Now, which fund families license that particular index?” And then you can go and make that selection.
So there are really two ways to do it. It’s a top-down or bottom-up.
Andrew Chen 19:27
That makes sense.
I was also curious. You mentioned in the first bucket, the classic index fund where it is just strictly tracking the index.
If the point of those funds is to minimize tracking errors, so they’re not trying to be active in any way, they don’t have any particular investment, they’re literally just tracking, I’m just curious, why can’t computers just do this and make the fees almost zero? Why do you need humans involved at all?
Jonathan Duong 19:59
I think there’s a few things. Realistically, if we’re being honest, we’re as close to zero to the point where shaving two or three basis points is basically meaningless at the end of the day, for all intents and purposes. So we’re basically darn close to there, even if we’re not technically there as far as zero cost.
But we’ve really reached a point now where trading ETFs is, for all intents and purposes, free from a transaction cost perspective. You still have to be mindful of the bid-ask spread and deviations from NAV and a lot of other things. But from a transactional cost, that’s zero.
The expense ratio, if your highest priority is cost, you can build a portfolio for three basis points or four basis points at this point.
That said, in terms of where I think we are going, I do think that’s a very viable possibility. The fact that it’s technically the S&P 500 index isn’t really that meaningful or important for most investors if their goal is just simply to invest in U.S. large cap companies.
So I think, increasingly, this is the democratization of investing for the world, and certainly for U.S. investors, where we’ve never had more choices at lower cost and easier access than ever before. And I think that’s going to continue.
I think there’s an increasing number of solutions now that are going to be focused on abandoning the index and allowing for “direct indexing” is what it’s largely called, where, even with a smaller portfolio, you may be able to (or a smaller amount of capital) recreate any index you want without necessarily having to utilize the index license or the index fund.
There’s a lot of research happening there, a lot of tools coming about, and I think that’s good. I just don’t see it as being nearly as transformational as the difference from, let’s say, an actively managed mutual fund charging 1.5% to a total stock market index charging five basis points. That’s a heck of a lot more meaningful for the average investor.
Andrew Chen 22:01
Yeah, that’s true. That’s a fair point. Cool.
That’s really good background on the different indexes, how you can research them.
Let’s say you’ve zeroed in on the index you want to add to your portfolio. Could you walk us through, step by step, your approach or best practices for how to actually evaluate particular funds?
Say there’s a fund you haven’t come across before. You’re trying to decide how good the fund is as an investment. Step by step, what are the attributes, the criteria, the performance indicators that you personally analyze to evaluate a fund?
Jonathan Duong 22:43
Again, I’m going to hark back to my financial planning mindset because I think it’s always so important to always ask yourself, “Why am I looking to add this fund?” or “Why am I looking to replace a fund in the portfolio?”
“Is it simply because I’m looking for the latest flavor of the day, or is it because the asset allocation that I’ve defined in my plan needs me to fill this particular slice of the portfolio, so therefore, I need to go ahead and review that?”
That’s the most important thing. Once I’ve established that and I say, “I’ve got this asset class slice or this sub-asset class slice that I need to fill,” then the things that I go through and look for, certainly like we talked about, the benchmark or the index is critically important.
I’m also looking at the actual underlying holdings within that fund. And if it’s a commercial index, obviously I’m expecting darn close to full replication. If it’s a passive-oriented investment but not a strict index, then I’m still going to go through and look at the underlying portfolio, and also to verify that the index is consistent with what I’m looking for.
Say for sake of argument, if you go look at U.S. small cap stocks or U.S. large value, some indices may have a couple hundred stocks. Some may have a thousand stocks. So it’s really important to understand how many positions are actually within this portfolio, and is that a sufficient level of diversification for what I’m seeking?
That’s another thing I consider. Next, of course, is fees and expenses. What is the underlying expense ratio of the fund?
In addition, are there other things that I need to be mindful of beyond just the expense ratio that could impact my net returns? Bid-ask spreads are certainly one of them, like we talked about.
Another, which we’re not going to go deep down the rabbit hole necessarily, is this idea of securities lending revenue, which is a strategy that certain funds and certain fund families utilize where they’re going to generate some additional revenue for the fund by lending out underlying securities, and that could be used to offset the actual fees and expenses in the fund.
Now, certain fund families give 100% of the revenue generated back to the investor. Other fund families only give a portion. And others keep it all for themselves as profit for the fund.
So I’m looking at all of the embedded costs. And then next, I’m looking at taxes. I’m trying to understand, what type of tax activity can I expect or should I expect in this particular fund?
And where does that make it appropriate to fit within my portfolio? Is it appropriate within my IRA or Roth IRA? Is it appropriate with my brokerage account or my taxable account?
And then, what can or should I expect in terms of breakdown between qualified dividends, non-qualified dividends, any embedded capital gains, other things like that? So I have to be really mindful of those things.
And that’s really just on the equity side. On the fixed income side, there’s a whole other series of things that we need to analyze. And it’s where I actually think, in a lot of cases, the comparison and nuances between fixed income can be even more in-depth than it could be on the equity side, even though I think most investors tend to focus on stocks because they’re more exciting.
Andrew Chen 25:51
If there is a pithy or short version of it, what are some of the indicators or metrics that you look at on the fixed income side?
Jonathan Duong 26:05
The big things, if we’re looking at what we can control as investors, we largely can control two things above all else.
That’s term, how long dated are the bonds we’re investing in, so how much risk we are taking by investing in shorter term, intermediate term, or long term bonds (what we call term risk), and the sensitivity (largely what we would call duration) to changes in interest rates, which is a similar evaluation.
We look at that, and then we look as well at credit risk. Am I investing in treasuries? Am I investing in corporate bonds, municipal bonds, so on and so forth?
Those are really the two parameters that we look at. And within that, there’s a whole lot to unpack.
We’re looking at, for example, on the yield side, what is the yield to maturity of the underlying funds? And obviously, no surprise, with interest rates being close to zero on high-quality debt, yields are at historic lows, so investors are faced with some challenges.
Are they willing, or do they need, to take more term risks (going from really short term to intermediate term or longer term bonds)? Or do they need to take credit risk in order to get some yield? And that’s a real challenge that we all face.
There’s a whole lot of detail to analyze and make comparisons there, but it largely can be thought about in those two buckets: term risk and credit risk. And then, of course, a lot of other considerations, whether it’s taxes, related to tax exempt interest and municipal bonds, inflation-protected bonds like tips or other things like that, certainly more detail there.
But that’s what I think most investors these days are really faced with is ultra-low interest rates and “What does that mean for my portfolio and my long term plan?”
Andrew Chen 27:47
Right now, given that rates are nearly zero, is this a pretty risk time to be investing in fixed income funds, let alone securities?
Jonathan Duong 28:02
It depends on how you define risk. If we define risk as the potential loss of principal, I don’t know that it’s really that different today than it was a year or two or three years ago, depending on which segment of the market you’re in.
But if we define risk as the long term risk of not reaching our financial goals or running out of money, then yeah, I do think it’s very significant for investors. Certainly inflation is really low, so that’s a benefit that most investors have.
We’re not facing rampant inflation. At the same time, we have incredibly low yields on debt or on fixed income. But I do think it’s going to be a challenge to a lot of investors.
To our clients, we’re really encouraging everyone to think through the tradeoffs. And the two most obvious are: “Do I take more risk on the bond side but keep my broad asset allocation?”
If I was a 60% stock, 40% bond investor, one option is I take my fixed income and I take more risk. So I’m adding more credit risk or I’m adding more term risk. That’s one option to get a little bit of increased yield.
The other is to say, “I want to keep my fixed income quality and duration where it is, but I’m going to add 5% or 10% to my stock allocation. So instead of being 60% stocks, I’m going to be 65% or 70% stocks.”
Now, there’s no perfect answer here. It’s definitely a series of tradeoffs.
But I do think investors are really going to have to give a lot of thought to their plan, whether they’re accumulating or whether they are decumulating and withdrawing. They’re going to have to give a lot of thought to can they tolerate the volatility of stocks?
And if so, my personal view, all else equal, is that the scariest thing in the near term, which is stock volatility, is likely going to be the thing that saves us over the long term, because simply putting a large percentage of our assets in an asset class like bonds that yields a quarter percent or half a percent is just not going to get it done.
Andrew Chen 30:04
I want to backtrack to something you said earlier, which is, you were talking about some of the attributes you evaluate to determine the worthiness of a fund. You mentioned things like the index itself, the holdings, the expense ratio. You also talked a little bit about taxes and the tax efficiency.
Where do investors look to analyze the tax profile of a fund?
Jonathan Duong 30:33
I think there’s really two things. In terms of direct feedback, you can go up to Morningstar or look at some of the other research websites, and they will give you a tax efficiency score or they’ll show you: are there any embedded capital gains you might be exposed to?
You can see distributions, those types of things. I think that’s one way.
In a more detailed, nuanced way, I can get a pretty good handle on flavor by looking at and reviewing the actual index and then knowing what type of index or asset class we’re focused on.
For example, not that I’m an advocate necessarily of a high dividend yield strategy, but I do know a lot of investors are, so you have to be mindful of, if you’re a dividend-focused investor, increasingly, we have the reality that dividend yield on many stock index portfolios is higher than the yield on the fixed income we own.
So we might be seeing a 2%, 3%, 3.5% dividend yield on our stock index fund. Meanwhile, our fixed income has a yield of 0.5% or 1%.
Now, the impact of that is going to be highly disparate in each individual’s tax situation, but we really have to look and understand that.
So, my longwinded way of saying is I can get a pretty good sense, based on the asset class we’re focused on and the index we’re focused on, can I expect that this is going to be a tax-efficient fund with minimal unexpected capital gains (ideally, qualified dividends and so on and so forth), or should I be expecting a lot of activity that could be pretty detrimental to the client?
That’s certainly one of the reasons why, from an investment perspective, if we’re looking at a high tax bracket and client where, let’s say, they’re in the 35% or 37% tax bracket, they’re also facing state taxes, we are very acutely focused on tax efficiency.
And that’s where, say for sake of argument, if we’re looking on the equity side, certainly a total stock market index fund is likely to be more efficient than a more narrow-focused index fund that only is holding a small basket of stocks.
And also where, if we are trying to tilt to size or value, where DFA or Dimensional Fund Advisors adds a lot of value because they’ve got total market funds, but that also weight to size and value within that total market fund.
This year, by all estimates, we’re not expecting to see any capital gains at all, even amidst the volatility and the growth we’ve seen since March. Certainly that’s a big focus, and particularly true of clients in California or New York or in other high state income tax states.
Andrew Chen 33:11
You mentioned embedded capital gains earlier. Can you explain what that is?
Jonathan Duong 33:18
I think one of the differences that investors do need to be mindful of when they’re looking at an ETF versus an open-end mutual fund is the ETF structure, the way that it’s designed and the share redemption process and so on, tends to make it more tax-efficient and tends to result in the case that it’s not going to distribute, in many cases, any capital gains going forward.
In other words, if you buy the fund and you don’t sell the fund, you should not expect anything beyond the dividends when you get your 1099 from your brokerage firm.
And that’s just a design feature of an ETF. That’s why they’re typically talked about as being tax-efficient, even though there are many good open-end mutual funds that are also equally tax-efficient.
But on the open-end mutual fund side, because of the way that the fund family has to redeem cash, or the fund manager has to redeem cash, when some investors want to sell and get out, other investors want to buy in, what can end up happening is the mutual fund itself can incur capital gains, and then it has to go in and distribute those out to the fund holders.
So what can happen is you could invest in a fund and you don’t sell, you never sell, and yet you’re getting a 1099 that has a capital gains distribution from the fund, simply because the mutual fund has to distribute that capital gain under the tax law.
Andrew Chen 34:40
So the fund manager is there just managing the normal inflows and outflows of cash into the fund.
If I’m understanding correctly, there may be times where they would actually have to liquidate assets in the fund, would incur capital gains at that point to the fund. So that’s the embedded part, and then they distribute those out in your 1099.
Jonathan Duong 35:00
Yeah. Or other examples, like we’re going to see likely some changes to the S&P 500 composition. And I don’t really track super closely the day-to-day composition of the S&P 500, but we’re going to see some entrance.
Tesla may come in. Other previous companies within the S&P 500 may leave. That can cause a capital gain in and of itself.
Now, is it the end of the world? No, but it’s one of the downsides of a commercial index tracking ETF or mutual fund is that the mutual fund manager or the ETF manager has no choice but to take these actions which can result in tax consequences.
And that’s just simply because they have to follow the index. They don’t have any latitude the way a passively managed one would.
Andrew Chen 35:45
Why are ETFs not exposed to that? Because they also have to strictly follow the index as well.
Jonathan Duong 35:50
They have an ability to synthesize the redemption process where they can actually go and sell out of a given portion of the fund and buy the underlying securities. And through that, they have the ability to manage that so that the actual net effect to the investor is not to actually ever have that capital gain be forced to fall through.
So it’s just a difference in the share redemption process, and it gives the ETF an inherent advantage. Not always in reality compared to a good and well-designed mutual fund, but it does give it that inherent advantage because of the redemption process that a mutual fund doesn’t have.
Andrew Chen 36:30
Talking a bit about expense ratios, what are the mechanics? How do expense ratios actually get deducted when you have money invested in an index fund? Is it literally they just take a percent of the AUM monthly, quarterly, annually, as the case may be, or is there more complexity to that?
Jonathan Duong 36:50
Most funds, it’s going to be a daily deduction. So when you look at performance, you’re always going to see performance net of fees, and that includes all of the cost structure within the fund.
So we have to understand that the fund certainly has an operating cost, an expense to operate the fund. And there are other costs that are embedded within the performance of the fund as well.
The expense ratio is typically going to be deducted on a pro rata basis, so 1/365 per day. So you’re always going to see net of fees performance.
But in addition, when a fund, let’s say, within it, it’s facing its own bid-ask spread. Not as big of a deal for, let’s say, U.S. large cap stocks where they’re super liquid, there’s a huge market, and the number of trades taking place every day in all of the names that are really hot right now, whether it’s Amazon or Apple or Microsoft or Google or otherwise.
There is incredible liquidity. It’s never an issue.
If you look at some of the more opaque areas in the market, say microcap stocks or small cap value stocks or otherwise, there actually can be bid-ask spreads legitimately that can detract from the returns of the fund. So you’re always going to get the net returns not only after paying expenses, but also after paying bid-ask spreads.
And then, on the upside, we talked earlier about securities lending revenue where, if the fund is generating securities lending revenue and giving that to the investors, then that can actually be a positive lift.
And there have been examples in the past of really well-run funds that generate enough securities lending revenue to actually fully cover the expense ratio, where the actual true cost of ownership in the fund is zero, or in some cases, negative.
Now, that’s not going to be very common at all, or probably won’t happen at all, in super large mega cap type funds, just because there’s no real huge market for security lending revenue there. But there can be in more opaque areas of the market.
So, investors just always have to remember, when they’re seeing performance, they’re seeing performance after all of the costs that are taking place within the fund itself.
Andrew Chen 39:03
What do you recommend are the best ways to search for index fund options to invest in?
In particular, are there any free tools that you recommend that are useful for searching and evaluating and filtering fund options? And what are best practices for using some of these tools?
Jonathan Duong 39:24
If you’re just starting out, I think Morningstar, etf.com, etfdb.com are good tools. They can help you with a top-down approach, for example.
ETFreplay is also a good tool to do testing and screen for ETFs. I think it’s another good one.
Once you’ve got a bit more experience, personally, I find that the absolute best place to go is the actual fund company’s website. I’m not going to say it’s always the case, but I think when data gets sent from the fund company into some of these huge resources or research tools, sometimes it gets a little lost in translation.
So I always want to go directly to the source. I’ll typically end up going directly to Vanguard, directly to iShares, to Dimensional, to SPDR, you name it, and some of the other upstart fund families as well. I’ll go directly there, and that’s where I’m going to go find all the information that I’m looking for.
But if you’re starting with a top-down approach, I think some of those resources can be pretty good and allow you to do a side-by-side comparison to get an idea, particularly when you’re searching across fund families.
If you’re comparing an iShares fund to a Vanguard fund, unless you’re going to go build the type of diligence spreadsheet that I would, you’re going to ultimately find it a lot easier to use a comparison tool like that.
Andrew Chen 40:53
You mentioned one tool: ETFreplay. Is that a tool where you run simulations?
Jonathan Duong 41:00
Yeah. You can do back tests. You can do simulations.
Obviously, my view and philosophy is you can back test your way to anything, so that’s not really how we should approach this. But rather, it’s helpful to better understand, for example, if we look at the COVID decline in February and March, I think it’s really instructional for investors to understand, “How did the bonds that I own actually respond in that type of a crisis?”
And there are many things to consider there, namely, when we look at the different asset classes, we certainly saw, if you had credit risk in your bond portfolio, if you had bonds that were not quite as liquid, for example, if you basically own anything other than treasuries and cash, you did see a volatility and decline.
So a tool like ETFreplay or some of the other tools can help you to understand, how did this asset class actually perform? Not that that’s a prediction to repeat into the future, but rather to better understand the risk that you’re taking in certain parts of your portfolio.
Andrew Chen 42:11
Awesome. Closing the tail end of the discussion, I wanted to get your thoughts on some specific names and ticker symbols of funds that you view as solid picks for investors who want exposure to different types of asset classes.
Maybe I’ll just rattle down a few of the asset classes, and if there’s one or two names that you tend to recommend… I actually don’t want to say “recommend” because that’s not what you’re really doing, but more that you think are potentially good picks to do some additional diligence for somebody who wants exposure to that asset class. I would love to get your thoughts.
U.S. Total Stock Market, to kick off?
Jonathan Duong 42:54
I’ll certainly start by saying I don’t work for Vanguard, I don’t work for Dimensional or CFA, but they tend to be the fund families that, after all the research, all the diligence that I’m doing, I feel like not only they meet all the criteria that we’ve already talked about here, but they also tend to be very investor-friendly, putting investors first and being very transparent as they do that.
So that tends to be, in most cases, I don’t need to leave those fund families. Not always, but in most cases.
Thankfully, there’s an increasing number of options, for sure, from iShares, from SPDR, from some upstarts like Avantis Investors as an example of some folks who have left VFA or Dimensional and are making some inroads through this new organization underneath American Century called Avantis. So that’s another.
To get back to your point in terms of U.S. Total Stock Market, certainly if we look at what Vanguard has to offer, I think VTI is the classic U.S. Total Stock Market and can be a really good tool. iShares has ITOT. It’s another good option.
And then, certainly, if you are working with a financial planner, a financial adviser who has access to Dimensional’s core and vector funds, I personally think if you are investing and you are looking to tilt to size and value, the core funds can be a great tool for that.
DFQTX or DFTCX are great tools because they allow you to do that size and value tilt, but within a total market structure, so it’s a lot more tax-efficient.
But the big thing is there’s just so many choices now. As long as it is a widely diversified index, you know what’s in it, and you’re paying a fair fee, you really can’t go wrong, for all intents and purposes. There are bigger fish to fry, let’s put it that way.
Andrew Chen 44:45
That’s a fair point. What about Total International Stock?
Jonathan Duong 44:50
On the international side, I think it’s important for investors to make the distinction to understand, are they taking that total international approach, like you’re mentioning, where they’re investing in not only developed market countries like Germany and France and Japan and so on, but also emerging market countries like the BRICS (Brazil, Russia, India, and China)?
If they are investing in that total market structure, again, I think Vanguard has got a great solution. VXUS, I think, is a really good tool. I think, as well, iShares, IXUS is their comparable option.
And then, alternatively, if investors are saying, “I want to control my exposure to developed markets, and then emerging markets separately,” then that’s where you might use something like a fund that tracks the MSCI EAFE index.
And then separately, in other emerging markets you’ll find, it might be any number of different indices that do that. That’s where you might use something like VEA and VWO from Vanguard.
iShares, I believe IDV is their developed market’s ETF. And then they have IEMG. That’s their emerging market’s fund solution.
So, it just depends on whether you’re taking that total market structure or you’re actually looking at developed markets as one bucket, emerging markets as another. And of course, you can go even deeper than that if you want to focus on Europe and then Asia-Pacific. You can really go as deep as you want.
Andrew Chen 46:14
Yeah, that makes sense. If you were to break them apart, it makes sense. If you wanted to have a bespoke composition in your portfolio between developed, emerging, or Europe or BRICS, or whatever the case may be, it would make sense to try to manage those separately.
But if you really wanted just a Total Stock Market ex-US, is there any advantage to holding separate funds as opposed to a singular fund that encapsulates all of it?
Jonathan Duong 46:43
Personally, if you’re not looking to control the weight on developed market versus emerging market, I wouldn’t recommend holding them separately. You’re going to end up with more tax efficiency if they’re together.
However, that said, one of the challenges you’ll run into is, if you are trying to implement a strategy beyond just a market cap weighted approach, then that’s where sometimes holding them separately can be more advantageous or more feasible, just because otherwise you end up having to own a whole bunch of funds in order to replicate that.
So, if you’re strictly looking at total market, I think that total international is a great approach. If you’re getting beyond that and you’re moving into a more detailed allocation, then there can be some very good reasons to separate them. It just depends on the specific investor portfolio.
Andrew Chen 47:36
What about dividend-focused stock?
Jonathan Duong 47:41
I think what’s important here for your listeners to think about is, are they focused on dividend yield in and of itself, or are they using dividend yield as a proxy for value investing? And an imperfect proxy at that.
If you’re looking specifically for dividend yield, then you obviously want to go and look at a dividend paying or a high dividend yield type of index. That’s going to be the approach that you’re going to want to take.
Alternatively, if you’re really looking at value investing, then that’s where, as far as what Vanguard or iShares or others offer, there are a whole host of different choices there.
And that’s actually where I think, on the equity side, investors who are considering deviating from a market cap weighted approach, they really have to understand what they’re investing in and be very mindful of how they’re approaching that, because that’s really where the difference between one index to another can be critically important.
Whereas it’s not quite as important if you’re, say, looking at a total stock market index fund, as long as you own the Russell 3000 or another example that owns 2500-3000 stocks, it’s going to be pretty similar.
So, on the dividend paying side, I’ll be honest, it’s not an area that I focus on a lot. It would be a whole another podcast to talk about dividend yield as a strategy.
But on the value side, I think what’s important to understand here is they’re not all created equal. The options that are available: Vanguard has, say, VTV for large cap value, VBR for small cap value. iShares, IJS for small cap value.
This is really where you could spend a whole podcast on the differences between these types of ETFs and the indices that are associated with them. It does start to matter a whole lot more.
But back to your question specifically on dividend-focused stocks, not an area that I spend a lot of time researching. And the rationale and reasoning there is probably subject for a whole another discussion.
Andrew Chen 49:42
What about U.S. investment grade bond?
Jonathan Duong 49:47
I think here, some really simple, straightforward choices if you want to own the total bond market, for all intents and purposes.
Now, there are exceptions to that, but what’s commonly referred to as the Total Bond Market Index, we’re looking at the U.S. Aggregate, the Barclays Agg or something like that. You could invest in BND as a Vanguard option.
If you want to go shorter term, BSV. Or intermediate term, BIV is another example. There are so many options.
I think if you’re looking at investment grade or core type fund, you just really have to understand, what are you actually investing in? Because a lot of funds will be labeled as “investment grade,” and I don’t think that’s a sufficient descriptor to understand what you’re actually investing in.
If it is truly tracking the Barclays Agg or something similar to that, then you’re pretty confident what’s in there. If it’s a different index, you better know what you’re actually investing in before you go and deploy capital.
Andrew Chen 50:46
Yeah, that’s fair. Is it fair to say that the larger brokerages that construct their own versions of these funds are just more likely to have the fund composition be closer to what you would expect when you hear something like investment grade bonds?
I think that’s what I’m hearing. Is that correct?
Jonathan Duong 51:04
Yeah. I think that’s probably reasonable to say.
Certainly, if it’s a true commercial index ETF or mutual fund, then the very name of the fund oftentimes is going to include the details that you care about. It might specifically reference it. If not, you can pretty quickly go and find out, is it tracking the Barclays Agg, or is it a credit index, or is it a treasury index or something like that?
All else equal, if you are looking, for example, at Vanguard total bond market index, or you’re looking at, let’s say, SPDR has their aggregate bond ETF, you can go and quickly look and say, “Yeah, it’s tracking the Bloomberg Barclays U.S. Agg,” and you can be pretty confident what you’re investing in there.
But because there are so many sub asset classes in bonds, you really do have to complete the requisite diligence. It goes without saying.
Andrew Chen 51:57
Makes sense. What about U.S. government and/or muni bonds?
Jonathan Duong 52:02
Here it’s going to really depend on term.
If you just want, say, short term treasury, Vanguard, VGSH basically tracks the one- to three-year U.S. treasury index. Really easy solution.
If you want to go a little bit longer term and go intermediate term treasuries, VGIT is a great solution there. SPDR, SPTI is an example. iShares, SPDR, Vanguard all have solutions really in this space, specifically on the treasury side.
On the municipal side, there are some options, but they’re not nearly as many as there are on the corporate or credit side and on the treasury side.
Probably one of the most famous municipal ETFs is MUB. It’s one of the more famous ones.
Vanguard released VTEB, which is their true tax-exempt bond index fund. Historically, their municipal bond funds are technically actively managed. It’s not anything that causes me any heartburn because they’re low cost, they’re very clear, very transparent, which is what matters most.
But historically, Vanguard hasn’t actually offered a municipal index fund. That changed a little while back, so they offer VTEB as an example.
There actually are others. You tend to have to do a little bit more digging because, historically, most of the municipal bond funds have been mutual funds, not actually ETFs. You do have to do a bit more digging on the tax-exempt side.
Andrew Chen 53:27
Interesting. Are there any major names from big brokerages that you suggest on the international investment grade bond front?
Jonathan Duong 53:40
Yeah. I think probably the most common one that a lot of investors are going to look at is the BNDX.
If you look at Vanguard, BND is a very well-known, huge U.S. fund. BNDX is its international complement. That’s certainly one.
In addition to that, Dimensional has got a lot of options here. We do look at, and historically have used, DFGBX, which is a global index fund. Also on our diligence list is DWFIX, which is an XUS fund as well.
I think what’s important here (and this is, again, a locker conversation) is investors have to understand, what are they using bonds for? If they are using bonds primarily as a tool to mitigate volatility, to reduce volatility and the potential for decline in their portfolio, then they need to be careful as they leave the traditional asset classes.
If they’re leaving investment grade U.S. debt, government, credit, tips, municipal, those types of things (and it is important to understand what you’re investing in there as well), and you’re moving into international debt or emerging market debt, you really need to understand what you’re investing in.
Because the last thing that you want to do is think that you’re invested in bonds and you’ve got stability there, and then find out that you’re seeing 10%, 20%, 30% declines on the bond side of your portfolio while your stocks are down 30%, 40%, 50%.
That’s just not a good recipe. And most investors don’t want that surprise to show up when the whole rest of the world seems like it’s ending.
Andrew Chen 55:22
Yeah. In the U.S., there are investment grade standards. There are ratings for debt in the U.S.
Internationally, when I think about investment grade bond index funds, do they utilize a common standardized rating type of rubric? Or is the word “investment grade” in the eye of the beholder when you cross the border outside of the U.S. and go to international markets?
Jonathan Duong 56:00
It’s certainly going to depend. There’s plenty of non-rated debt. If we’re actually looking at what’s in the portfolio, there’s plenty of non-rated debt even in the U.S.
Most people think about the rating agencies: S&P, Moody’s, Fitch, and so on. They look at those ratings. We’ve seen plenty of cases in the past where those ratings don’t tell the whole story.
But even in the U.S., there’s plenty of non-rated debt where, say, on the municipal side is a good example where there are plenty of municipalities that, because they bear the cost of having that debt rated, they’ll just wave on that and say, “Hey, we’re not going to go ahead and pay to get it rated. Instead, we’re just simply going to bring it out to market.”
And what’s going to end up happening is there’s going to typically be a higher yield or a higher expected return because of the uncertainty. But if you’ve got a good fund manager that really understands what is there, what they’re investing in, it’s widely diversified, and so on, that isn’t necessarily a bad thing.
On the international side, if we’re leaving the traditional U.S. core debt market, then as we’re leaving that, I think we have to be very mindful of investing in an index and benchmark that we actually understand. And of course, thankfully, there are some really good benchmarks or indices there that we can be fairly confident that we know what it is that we’re investing in.
I think that’s really important. And I think peeling back the onion further is important. But I don’t think, on the surface, non-rated debt is immediately like “Hey, this is awful” because that can apply even in the state.
So I think it is important to really understand what is it that you’re investing in, not just relying on the rating in and of itself, although that can be a good proxy to better understand. I think it’s more important to understand how much is in government debt, how much is in corporate debt, how much is securitized or mortgage-backed securities or otherwise. That’s what’s going to really help an investor better understand what they’re actually investing in.
Andrew Chen 58:01
Good advice. Any suggestions for real estate?
Jonathan Duong 58:05
Yeah. A lot of good choices here, or an increasing number of good choices here, as far as U.S. REITs and international REITs. Again, I’m going to go to the well because I’ve always been an advocate of Vanguard.
Certainly, the ones that are my personal favorites as far as looking at the diligence list, looking at all the other things we talked about, VNQ and VNQI on the U.S. international side. And then from Dimensional, DFREX and DFITX. Those four represent a really good mix.
But same story. If you are looking at the underlying index and you’re looking at understanding
“Am I invested in the Dow Jones, U.S. Select, or the MSCI US REIT?” if I understand what it is that I’m looking to invest in, and if I can get that through iShares or SPDR at a reasonable cost, then at the end of the day, it doesn’t matter nearly as much. And that’s where you have to look at more of the details.
Same story of understanding what I’m investing in first, and then going to the market and saying, “Who offers what it is that I’m looking for?” An increasing number of options, thankfully, and so many fund families we get to choose from.
Andrew Chen 59:18
And I got one more for you. Last one.
U.S. total market across all asset classes, or alternatively, an all weather portfolio, if the investor just wants to buy one name and get exposure to everything?
Jonathan Duong 59:34
The way I always frame this, particularly for clients who do manage investments themselves or are looking for a solution in their 401(k), if they’ve got a limited investment, is you have to decide, because the two flavors for a multi-asset class portfolio, in most cases, particularly in the index world, is: are you going to select a fixed asset allocation strategy, or is it going to be a glide path like a target date fund?
Most of your listeners probably know target date funds, most of them, if you’re young, right out of school, and so you’ve got a long time horizon in front of you, say 40 years or something like that, then the asset allocation is going to be probably 90% stocks, as an example, and it will allocate across U.S. international emerging markets, and then a small percentage in debt and cash.
And then over time, that portfolio will get more conservative as that investor gets closer to their target retirement date, say 2040 or 2045 or whatever the case is.
The other type of approach, the fixed asset allocation approach, where that asset allocation remains exactly the same. It doesn’t change; it doesn’t glide. It’s going to be the same today as it is 10 years from now.
So, investors really have to think about that. Do they want a dynamic approach or a fixed approach? And then within that, then you can make your decision.
On the Vanguard side, they’ve got their target retirement funds. There are so many other fund families that offer similar things, whether it’s TIAA-CREF, BlackRock, or Schwab. Almost every fund family these days has a target date or a retirement type fund.
And then, alternatively, on the fixed asset allocation side, Vanguard has LifeStrategy funds, which, if you want to pick a 60/40 allocation or an 80/20 allocation or so on, and you want it to remain in place and not change, then that’s where those are a good solution.
I think investors just have to think about: are they looking for something that is designed to approximate that transition in asset class, asset allocation over time, or are they going to manually make those changes at certain points over time in their progress towards retirement?
Again, that all comes back to your financial plan and thinking through where you are, how you’re progressing, what rate of return you need, and so on and so forth.
Andrew Chen 1:01:48
Jonathan, this has been super insightful, really action-packed. I really appreciate your taking the time to chat with us. Where can listeners find out more about you, your practice, your services, etc.?
Jonathan Duong 1:02:00
Great conversation. Honestly, I could talk about due diligence on ETFs and mutual funds all day long. This stuff is certainly interesting, and I hope that your listeners are able to take something from this and add it to what it is that they’re doing.
As far as what we do, best place to find us is on our primary website, which is wealthengineersllc.com. You can read more about our approach and process there.
Certainly, investing is a part of what we do. But like we talked about at the beginning, wealth planning and strategy is so much more than just investing.
It’s tax planning and strategy. It’s healthcare and employee benefits and those types of things, tax planning, estate planning, insurance. It’s really all of that.
While I started my firm really focused on super detailed, nuanced investing strategy, as far as our public web presence, it’s a lot more focused on overall broad wealth planning, so we don’t have as much of that up there. We still have quite a bit of research and other things like that that we post.
So that’s the best place to find us. And anybody who has questions, you’re welcome to reach out via email or schedule calls if you like to learn more.
Andrew Chen 1:03:12
Awesome. We look forward to sharing this with our audience, and we’ll link to all that stuff in the show notes. Thanks so much again, and best of luck with everything.
Jonathan Duong 1:03:20
Yeah, absolutely. I appreciate the time. Great conversation.
I hope everyone, including yourself, has a happy Thanksgiving. And I certainly hope that we can stay in touch and keep the conversation going.
Andrew Chen 1:03:30
Cheers! Take care.
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