Should I convert VEIEX to VWO ETF?

Vanguard has been offering ETF classes of several of their conventional mutual shares for some time now. One of the most interesting feature, which is unique to Vanguard as far as I know, is the ability for an investor to convert shares in the mutual fund to ETF shares for a fee of $50 (free for Flagship clients if done directly at Vanguard). This conversion is one-way only — you cannot convert ETF shares into mutual fund shares.

Why convert?

  1. The main reason why an investor would want to convert mutual fund shares to the ETF class is because the expense ratios of ETF shares are lower than the investor class mutual fund shares. For example, the Vanguard emerging markets index mutual fund VEIEX charges 0.37% annually while the ETF version VWO charges only 0.25% a year.
  2. A second reason is the possibly better tax efficiency in terms of capital gains distributions.
  3. The third reason is the redemption fees savings. For certain mutual funds with redemption fees (most notably VEIEX and VTMGX), converting mutual fund shares to the ETF class and then selling the ETF shares would save a bundle on the redemption fees (0.5% for VEIEX and 1% for VTMGX shares owned for less than 5 years), especially if the amount is substamtially more than $1000.

Why not to convert?

  1. If an investor already owns admiral shares of the mutual fund, there is little (if any at all) saving in the expense ratio. For example, the admiral class of Vanguard’s emerging market index fund VEMAX and VWO both charges the same 0.25% expense ratio a year.
  2. ETFs could trade at a premium or discount, in addition to a trading spread (trading spread is the difference between the bid and asking prices). A person investing in mutual fund shares does not have to be concerned with purchasing or selling shares trading at a premium or discount, nor be concerned with the cost associated with the trading spread. Mutual funds shares are bought and solt at NAV (net asset value).
  3. If an investor is contributing regularly, purchasing the mutual fund “generally” has no transaction fee while purchasing an ETF would normally entail a brokerage commission charge (unless the investor is using a free-trade broker). The brokerage fees could add up quickly to a substantial amount. Note: I say “generally” because one mutual fund exception is VEIEX, which charges a 0.5% purchase fee.

The case for VEIEX to VWO conversion

After looking at the pros and cons, let’s examine the specific case for VEIEX to VWO conversion.

Expense ratio saving. If an investor is holding a substantial amount of VEIEX (say from the low four digit range onwards), there is definitely a saving when the holding is converted to VWO. The current expense ratio saving is 0.37% – 0.25% = 0.12% or 12 bps (bps = basis points) per year. This difference, compounded over many years, could become substantial.

To see if this expense ratio saving really does make a difference in the performance numbers, let’s look at the historical performance of VEIEX and VWO for the years ended Oct 31, 2006 and 2007 (values taken from the prospectus):

  2006 2007
VEIEX (investor shares, ER=0.42% in 2006, ER=0.37% in 2007) 32.55% 69.59%
VWO (ETF, ER=0.25%) 32.74% 69.78%
VEMAX (admiral shares, ER=0.25%) N.A. 69.82%

Clearly, VWO outperformed VEIEX by 0.19% in both 2006 and 2007, the first two full years of its existence.

Trading spreads. There could be a trading spread cost in selling VWO in the future during the withdrawal phase. However, from my observations, the trading volume and liquidity of VWO has been improving through the months. The impact of trading spread cost should be relatively low. Furthermore, a 12 bps expense ratio difference a year would turn into (1.0012^20)-1 = 2.43% difference in 20 years time. This should mitigate any trading spread cost.

Redemption fee. Converting the mutual fund shares to the ETF class is one way to avoid the 0.5% redemption fee.

Conversion fee. As already mentioned, Vanguard charges a $50 conversion fee unless the investor is a Flagship client. Below, we will briefly look at how this fee would affect the conversion decision.

In the analysis, assume that the $50 fee to pay for the conversion comes out from the original VEIEX investment (tax consequences not considered for simplicity). Let R be the approximate investment return a year, X be the original investment amount and N be the number of years the investment is held.

Then the value of the investment after N years, would be given by

  • X*(1+R-0.0012)^N for VEIEX
  • (X-50)*(1+R)^N for VWO

For VEIEX, the compounding rate is reduced by the expense ratio difference of 0.0012 a year. For VWO, the original investment amount is reduced by $50 due to the conversion fee.

For the conversion to be worthwhile, we require (X-50)*(1+R)^N to be larger than X*(1+R-0.0012)^N. For example, if R = 0.1 (10% return a year), N = 10 years, solving the inequality gives X > 4606. This means that given the assumptions, it is better to convert if the original investment amount X is at least $4606.

Other scenarios are given in the table below.

2008-04-12-etfconversionbreakeven.png

Summary

It appears that for my situation, it makes a lot of sense to convert my VEIEX holding to VWO. This is especially so given that the investment is in the mid five digit amount and the conversion will be free for me. For investors who have to pay the conversion fee, the table above may help to decide if paying the $50 fee is worthwhile.

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    6 Responses to “Should I convert VEIEX to VWO ETF?”

    1. indexfundfan @ indextown » Blog Archive » Is it worthwhile to pay the ETF conversion fee? Says:

      [...] indexfundfan @ indextown Personal finance and investing in mutual funds and ETFs « Should I convert VEIEX to VWO ETF? [...]

    2. stan1 Says:

      One thought on the investment horizon. You will get Admiral shares when your investments in any fund grow to $100K or $50K after holding for 10 years. I have decided to stick with my Investor class Total Stock Market shares because I should be able to get Admiral shares in about 4 more years. I did convert Emerging Markets and Tax Managed Intl to their ETF share classes. The most disturbing feature of the conversion process is that the old mutual fund shares you are converting will disapear from your mutual fund account for a few days before the new ETF shares show up in your brokerage account. The VBS phone rep wanred me this would happen, and everything was good within 3 working days. Not sure how this will work at other brokerages if you are not doing the conversion at VBS.

    3. indexfundfan Says:

      stan1, I have the Total Stock Market admiral shares and I am not converting them. I had held out converting the emerging markets fund until recently to save on the conversion fee. I will probably convert tax managed intl soon because I intend to tax harvest my most recent purchases (no redemption fee on ETF shares).

    4. indexfundfan @ indextown » Blog Archive » Review of VEIEX to VWO ETF conversion at VBS Says:

      [...] various reasons already discussed (Should I convert…? and Is it worthwhile to pay the ETF conversion fee?), I recently converted my Vanguard Emerging [...]

    5. dave.d Says:

      The second possible reason cited for converting — “the possibly better tax efficiency in terms of capital gains distributions” — is not valid as stated. The ETF share class will have exactly the same capital gain distributions as the open-ended fund, because they are the same fund. Some tax benefit will accrue to the combined fund from the destruction of low-basis shares in ETF redemptions by authorized participants, but that benefit will be shared with investors in the open-ended fund.

      However, there is a tax-related advantage to holding the ETF, in that Vanguard Brokerage Service supports on-line tracking of tax cost lots on vanguard.com, which can be set (upon request) to track the sale of highest-cost shares first (HIFO). HIFO will result in optimal or near-optimal tax results, for example when tax-loss harvesting. It may still be necessary for compliance with IRS rules to call VBS the same day of each sale, and ask them to note on your confirmation that you are selling the highest-cost shares. Still, after entering the tax lots upon conversion, the online tracking will save a lot of tedious work — especially in a volatile asset class like emerging markets where you are likely to have both purchases and sales if you rebalance periodically.

      I understand that Vanguard is also now supporting specific share ID to some extent in the open-ended funds, but apparently this must be requested by telephone and is not tracked online. I have not used this feature and can’t really comment or explain. This last might be a good topic for a future piece, if not already done.

      THANKS
      dave.d

    6. indexfundfan Says:

      dave.d, thanks for your comments. It’s interesting that you should mention about specific share ID. Recently I tax-harvested my Total Stock Market index mutual fund using specific share identification and I do intend to write about it. ;-)