ETF Education

Should You Replace Your Index Fund with an ETF?

Vanguard's Vipers offer a tax-free way to limit market losses.

by Sue Stevens, CFA, CFP, CPA, Morningstar, 12-06-05

One of the best reasons to invest in exchange-traded funds (ETF) is that you can gain exposure to a specific market segment at a very low cost. There may be, for example, an ETF strategy that could protect your large indexed positions. Consider this: What if you could move the money you currently have in index funds to an ETF with no tax consequences and then put a stop loss order in on the ETF to sell at a specific price?

Today we'll focus on the ETFs known as Vanguard Vipers because of some unique planning opportunities. But first, a little background on trading and ETFs.

Stop Loss Orders
A stop loss order is a sell order at a specified price. You can set up the stop loss order with your broker for a predetermined time period or indefinitely ("good until canceled"). There is no cost to place the stop loss order. You just pay the transaction costs as you would for any sale.

Stop loss orders can be placed on any type of stock transaction. Because ETFs trade like stocks, you can use stop loss orders to sell them. You can't place stop loss orders on mutual funds.

So for instance, if I bought Vanguard Total Stock Market VIPER VTI at $125, I could enter a stop loss order for $110 (you can choose any stop loss price). That would mean that if the share price of VTI dropped to $110, it would automatically trigger a sale. If the share price didn't drop to that level, nothing would happen.

For many of you, the losses of the bear market that began in 2000 are still fresh in your minds. This strategy of putting stop loss orders on ETFs could help you implement your sell criteria. (You do have sell criteria, don't you? If you don't know what I'm talking about, read "Getting Your Portfolio on the Right Track" on Morningstar.com.)

Who Should Consider This Strategy?
If you have significant index positions that you typically just hold, you may want to think about this idea. With ETFs, the general rule is the fewer transactions you make, the better.

One of the downsides of ETFs is that you are charged brokerage fees every time you make a trade. That's in addition to the annual expenses. Both mutual funds and ETFs will have annual expenses, but you may be able to buy a mutual fund with no brokerage fees. (That would apply to most funds purchased at NAV. If you trade through a mutual fund "supermarket," the no-transaction-fee funds typically don't have additional brokerage fees.)

If you expect to be adding to your shares or taking out distributions frequently, then ETFs may not be for you. (In this case, index funds may also have restrictions on frequent trading.)

Playing devil's advocate for a moment, there may be other reasons why this strategy is not for everyone. By placing the stop loss order, you've made one decision about when to sell. You may get that right, but then you also have the decision about when to "get back in." So now we're talking about making at least two decisions: when to sell and when to buy. Unless you're willing to ride out market fluctuations, we're talking about market-timing.

Vanguard Vipers: Location Matters
We're going to focus on Vanguard today because of a unique opportunity: Vanguard offers both index mutual funds and exchange-traded funds, and also the ability to move from fund to ETF with no tax consequences. Many of the other ETF providers don't offer both types of vehicles and hence no tax-free conversions.

If you sell a Vanguard index fund and buy a Vanguard ETF, it can be considered a share-class conversion with no tax implications. (By the way, you can go from index fund to ETF, but not vice versa.)

Many of you may have been hesitant to make this type of transaction for fear you would trigger capital gains. But in the specific case of Vanguard index fund to Vanguard ETF, it's considered a "conversion" or "interclass exchange" with no tax consequences. It's similar to moving to the Admiral share class of a Vanguard fund. (Admiral share classes have higher minimum investments and lower expense ratios.)

Once you've accomplished the exchange, you can go on to place a stop loss order as part of a broader strategy to limit market losses.