Where Should I Invest?

It’s a battle royal for your money.  Who do you invest with?  The biggest players are of course Vanguard, Fidelity, and Schwab.  So which one should you deposit your hard earned savings with?

Long ago I wrote a piece about how index funds are the best choice for the bulk of your stock investment portfolio.  I stand by that assertion.  But which index fund to choose?  There are many out there.  But the 3 largest are Vanguard, Fidelity, and Schwab.  So which of the 3 is the best?

Vanguard

Vanguard was founded in 1975.  Their founding is practically investment legend.  They, under then founder John Bogle, started the entire index investment movement.   Today they also represent the largest of the big 3 index fund companies.  

More interestingly they are managed differently than the other two companies.  Essentially the funds of Vanguard own the company.  There is no shareholder or family office for Vanguard to be beholden too, only individual funds.  The structure in itself could potentially remove conflicts of interest between investors and shareholders/owners of the company itself.  Besides, they’ve been doing this a long time, so their reputation does come into play.

Fidelity

Fidelity is an even older company then Vanguard.  Formed in 1946 and operated as various spinoffs over the years.  Now a private company,   Fidelity’s entry into the index fund space came much later then Vanguards.  However, as of late they have made more of a splash then Vanguard.

Low Expense Ratio Price War 

You see the big value of index funds is their low expense ratio.  Historically actively managed funds have high fees and these have taken large cuts of individual’s portfolios. As individuals have begun to take notice of the value of low expense ratios companies have grasped ahold of the desire for low expense ratios as a marketing tool.  In essence, having low expenses has become a race to the bottom between the big 3 brokerages.  Who can achieve the lowest cost index fund will capture the most customers.  Well, a few months ago Fidelity one-upped both its competitors by releasing the first fund with 0 expenses.  It was quite the marketing coup, though as we shall see later it may not mean as much to actual investor outcomes.

Schwab

Anyway, continuing with introducing the players. Charles Schwab meanwhile was formed around the same time as Vanguard, 1971.  It too has entered the low expense ratio index market in full force.  Their unique hook seems to be customer service.  Vanguard has a bit of a reputation of having poor customer service for their brokerage house.  Fidelity has a decent reputation.  Well, Schwab meanwhile has gone full bore into the world of service differentiation.  They have essentially established things like free robo-advisors to capture additional clients.  I’ve questions the value of said robo-advisors before and I stand by that finding.  Add to that the tendency of these to steer at least some money towards Schwab Cash investments (that are poor return) and it’s not all roses.  But on the whole, its obvious Schwab is trying to compete both on price and experience compared to the other two choices.

Where to Invest?

So which is better?  Well without spoiling the outcome too ahead of time, I’d argue any of them are a fine choice.    Honestly, the best decider is probably which brokerage you park your money at rather than which fund.  Each of these options provides free trading in their own funds and charges to trade other funds.  They do the same for ETFS.  (For an explanation of ETFS versus Mutual Funds see here ).  That means if you have say a Schwab account it doesn’t make sense to hold Mutual Funds from Vanguard in it because you’ll be charged a trading fee.  The same goes for any other combination.  So really the brokerage account services that best fit your needs should currently define whose index funds you invest in.

What About Lower Expense Ratios?

Don’t believe me?  Your saying, but Fidelity’s funds are 0% expense fees while a trading fees only 20 dollars and you are investing a large number.  Well yes, investing a  large number negates the trading fee so long as you limit trading.   However, remember if you are adding money over time then each add is another trading fee. Meanwhile, the 0% expense fee example is not apples to oranges with your other choices.  It’s more marketing then significant impact.

How so?  Well, let’s start with expense ratio.  Schwab’s S&P 500 index fund has a expense ratio of .03.  Fidelity is 0.  Vanguard is .04.  So it sounds like Fidelity is the clear winner?  But is it?

Understanding Impact of a 0 Percent Expense Ratio on your Investments

Well, the first thing to understand is what the difference between .04% and 0 percent really is.  On a $10,000 investment this amounts to $4 dollars a year.  Hardly, earth-shattering difference there, you can buy a latte a year from moving your $10K to another broker and fund.  

How Funds Make Money

But wait there is more.  These funds are not completely apples to oranges comparison.  I know you are going, but they follow the same index.  Sure they do.  But the underlieing investment is not the only way these funds make return.   This is important as it makes up for the dreaded tracking error.  All funds will tend to lag their index by a small amount left alone just due to trading costs.   These funds offset the tracking error through other non-stock investing techniques?  How?  Well for that you need to understand some of the mechanisms funds use to lower costs and boost returns.

How Funds Lower Cost and Boost Returns

Particularly funds loan out shares.  It’s not talked about often, but essentially funds loan out shares they hold in exchange for collateral from lenders.  This is done primarily when someone does something like short a stock.  In this case, in order to short the stock they must borrow the stock itself.    They essentially borrow the stock from a mutual fund in exchange for some collateral.  The fund collects interest on both the collateral and, hopefully, when the stock is returned the appreciation on their original stock holding.  In essence, this can boost the return of the fund beyond the underlying index.   

Lending stocks more efficiently, applying more of its return to the fund rather than payments to managers, or other steps can mean this process leads to better performance of one index fund over the other.  All 3 of Fidelity, Vanguard, and Schwab state lending fees stay with their funds.  Vanguard has a reputation of being more adept at this, probably because their sheer size dwarfs the other two combined.    Size means economy of scale after all.  That being said even Vanguard’s usage of share loaning does not make that large of a return gap between it and it’s competitors.  Again we are probably only talking about a few dollars at best, hardly worth switching providers over. Still, it does muddy the direct comparison of a minimal expense ratio.

Risks of Securities Lending

Note there are risks to this activity.  The collateral could decline in value.  The loaner party could get into trouble and not be able to cover the short.  There is even the possibility that the fund could invest the proceeds from collateral incorrectly.    That being said the risk is probably minimal on the scale it is being done.  It’s usually a small proportion of the indexes overall funds, especially in a large-cap index.  Popular stocks are widely available so lending is less common.  Small caps and other lower volume stocks are much more likely to be lended.  This practice is also widespread between all the major funds, so it’s not something you could easily avoid even if desired.    As such I wouldn’t let it keep you up at night that this is going on, just be aware.

Trading Fees Can Add Up Over Time

So we’ve established so far that the real financial difference between the three largest index funds is probably a Latte at your local coffee shop for every $10K.  Hardly enough to drive a change.  But what about those trading fees?  Well on the face of it say $20 to trade a mutual fund doesn’t sound like much.  But what if you have the typical investor profile where your money trickles in over a year with each paycheck?   If you get paid 2x a month you are incurring $480 in trading fees each year as you deposit funds.  That before we talk about withdrawals.  If you consider even on the higher end most investors invest less then $100K a year.  If we used $100K at the high end your now comparing an expense ratio difference of $40 to a $480 charge.  I know which I’d volunteer for.  

Minimum Investment and Choosing Where To Invest

But wait there is more.  Most mutual funds have minimum investment amounts.  With the exception of the Fidelity 0 funds most of the bigger houses require you to invest at least $10K into the fund to get the version with the lowest expense ratio.  Well, starting out you are likely to take time to build the investment to $10K.  That means you may only have access to higher fee funds until you reach that plateau at some brokerage houses. Not good.  If you are looking at index funds with low investment amounts, and you must go with mutual funds, you are probably best off with the new Fidelity funds due to the low entry criteria.

ETFS and Avoiding Minimum Investing Amounts

But…  Honestly, this may all be moot.  If you are like me you might prefer ETFs.  Why?  Frankly, they tend not to have minimum investment amounts.  Like brokerage run mutual funds they also tend to be allowed to trade charge free if you stay in the same family.  So in my case, I favor ETFs unless I’m investing a large sum at once in a mutual fund to start out.   For example, if you inherited money or in my case sold everything to do a Roth conversion.     I still hold both ETF and Mutual Funds personally because I prefer diversification. 

You Can’t Lose No Matter Where You Choose to Invest

I know you were expecting a winner in this cage match, but the simple reality is the true winner is you.  No matter which you choose you win.  So long as they continue to compete on costs the picture will continue to improve for us the investor.  

Which brokerage house do you invest with?

*Disclaimer: I receive nothing from any of the brokerage houses mentioned here for this article.  I have funds with 2 of the 3 brokerages listed here as a factor of both work and personal accounts.    I have no preference between the 2.  I prefer to hold my funds across 2 accounts for brokerage insurance reasons, a post for another day.