A perfect ETF?

A Vanguard fund is exactly tracking its benchmark, meaning that, momentarily, it's free for investors.

By Bloomberg News

May 21, 2015 @ 11:58 pm EST

Every ETF has room for improvement. Except, perhaps, for one.

It's the Vanguard Total Stock Market exchanged-traded fund (VTI). While it has always provided dirt-cheap access to the full breadth and depth of the U.S. stock market, it is now returning the exact same amount as the stock index it's based on. Both are up 4.2% so far this year. That means investors are effectively getting free exposure to 99% of the investible U.S. stock market through 3,700 large-, mid-, and small-cap stocks.

How does that work?

Vanguard charges investors an annual fee of 0.05% of the money they put into VTI, which it reaps over the course of a year. That's about as cheap as it gets, but it's not quite free. So you'd expect VTI to miss its index's return by 0.05%, since the expense ratio comes out of the ETF's return.

But Vanguard is able to lend out up to one-third of the securities in the fund to short sellers. It collects a small rental fee for this service and puts all that revenue back into the ETF. This can partly offset the expense ratio, the percentage of assets an ETF issuer takes for managing the fund.

In addition, Vanguard's portfolio managers may be able to earn back another basis point (a hundredth of a percentage point) or two of the expense ratio simply with their acumen in managing the fund. The index that VTI is based on, the CRSP US Total Market Index, isn't static. It rebalances its holdings each quarter and is affected by IPOs, mergers and acquisitions, and the like. All these can help a shrewd manager pick up another grain of gain to put back into the ETF. (An ETF is a fund that tracks an index but trades on an exchange like a stock.)


This process of reducing, or eliminating, the tracking difference with the index is how Vanguard's managers are measured and rewarded internally. And this is why passive fund management is called a game of basis points, compared with the work of active managers, who try to beat an index. For these unsung passive managers, it's tie or lose. But tying is winning when it comes to index funds, because investors get every last drop of their market exposure.

VTI, which was launched in 2001, hasn't always had, and won't always have, exactly the same return as the index it tracks. But it rarely goes awry by more than a basis point or two. This is the minuscule level of cost and tracking that only the largest institutions can get in their separately managed accounts. VTI makes it possible for everyone to have it that good.

Then there's VTI's lifetime track record of making no capital gains distributions, an advantage because investors don't have to pay a dime in taxes until they decide to sell the fund.

VTI now trades $250 million of shares a day, about the same as Lockheed Martin stock. That volume helps suppress the cost to trade it. The spread between what investors pay for shares in VTI and what they sell them for (the bid-ask spread) now averages just 0.01%. It can't get much lower.

About 30 to 40 ETFs, out of the universe of 1,707, can make make the same claim, and many can also boast of making no capital gains distributions. But when it comes to cost of trading, expense ratio, tightness in tracking an index, and breadth of exposure to stocks, VTI is the cheapest and deepest of the lot.

The sweet deal that VTI offers isn't lost on investors. It recently become the largest ETF in Vanguard's stable and the fourth-largest ETF overall, at $55 billion in assets. When it comes to fund flows, VTI is like a giant vacuum cleaner, sucking in an average of $700 million of investor money a month.

Even in January, when VTI lost 2.7% as stocks were sold off, it still took in more than $1 billion in cash. People aren't playing this ETF for short-term gain. They're investing in it for the long haul.

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