ETF

Review of VEIEX to VWO ETF conversion at VBS

For various reasons already discussed (Should I convert…? and Is it worthwhile to pay the ETF conversion fee?), I recently converted my Vanguard Emerging Markets Index mutual fund holding (VEIEX) to the ETF class of the fund (VWO). The following is a review of the conversion process.

Prior to conversion

My VEIEX holding is in the taxable account with Vanguard. From the prospectus, it is stated that:

If you convert your conventional shares to ETF Shares through Vanguard Brokerage, all conventional shares for which you request conversion will be converted into ETF Shares of equivalent value. Because no fractional shares will have to be sold, the transaction will be 100% tax-free. Vanguard Brokerage does not impose a conversion fee over and above the fee imposed by Vanguard.

I was especially curious about the “100% tax-free” part because it implies that VBS must be supporting some kind of fractional share tracking. I sent Vanguard a secure email, asking specifically if VBS supports the trading of partial ETF shares. The following is their reply:

With regard to your question, depending on the conversion rate of the fund, it could be possible for you to end up with fractional shares of an ETF. In order to sell fractional shares in your brokerage account, you would need to sell your entire whole share position in the given security. Any remaining fractional shares will automatically be sold on the settlement date of the transaction, which is normally three business days after the trade date. For example, if you own 500.346 shares of XYZ Inc., you would simply enter an order to sell 500 shares of XYZ. When the trade settles three business days later, the fractional shares are automatically liquidated and no additional commissions are charged.

I think their reply is reasonable: VBS does not support the trading of partial shares; but if you sell the entire holding, the partial shares will be liquidated automatically without any additional charge.

Note: I asked the same question on the Bogleheads forum and received answers from jeffarvon and stan1 even before Vanguard replied.

The conversion

I called up Vanguard Flagship service on a Wednesday morning and told the rep what I wanted to do. He first made sure that I already have a VBS account and then transferred me to the VBS department. The VBS rep confirmed the following:

  • No fees for the conversion for Flagship clients.
  • The conversion is completely tax free. Vanguard will exchange fractional shares if necessary.

I was also told that I can enter the cost basis of the tax lots into the system at VBS after the conversion. The tax lots can be broken into fractional share if necessary. I told the rep to go ahead with the conversion.

On Wednesday night, I noticed my VEIEX holding was zeroed out. Under the “Transaction History” tab, an entry with transction type “Conversion from” was added. The mouse-over balloon shows the information on the conversion prices (for VEIEX and VWO) and the number of shares of VWO I would get. At this point, the VWO shares have not been deposited into my VBS account.

On Thursday night, the correct number of VWO shares were deposited into my VBS account.

After the conversion

What that is left for me to do after the conversion is to enter in the tax lot information. I had already prepared this information before hand and calculated the equivalent number of VWO shares for each tax lot in a spreadsheet.

To enter the cost basis, I clicked on the “Cost Basis” link under the VBS account, and then followed by the “Enter cost” link. This takes me to the following page:

2008-04-12-vwo-tax-lots.png

By default, only five lines for data entry are available but more lines can be added by using the “save and insert more lines” link. I successfully entered in 32 tax lots. After I submitted the information, it took one business day for the data to be updated.

Overall, the conversion process was done without any hiccups. The most painful part was actually for me to get information of the 32 tax lots and then enter them into the system.

Is it worthwhile to pay the ETF conversion fee?

Based on my previous post on whether to convert my VEIEX (Vanguard Emerging Market Index Fund) holding to VWO (ETF class), I thought it would be a good exercise for me to try to build a simple calculator to compute the breakeven investment amount for investors who need to pay the $50 conversion fee.

The calculator below will find the breakeven point which will make it worthwhile to perform the mutual fund to ETF conversion. The calculator inputs are as follows.

  1. The conversion fee, currently $50. Enter 50.
  2. The ETF expense ratio saving. For example, VEIEX ER=0.37% and VWO ER=0.25%. The difference is 0.12%, enter as 12.
  3. The investment horizon in years.
  4. The expected annual return. If the expected annual return is 8%, enter 8.

When the investment amount to be converted is higher than that calculated, a conversion would be worthwhile (assuming the assumptions are true). Note that as mentioned in the previous post, taxes are not considered in the computations.

ETF Conversion Decision Calculator

Conversion fee (in $)
Expense ratio saving (in bps; 100 bps = 1%)
Investment horizon (in years)
Expected return a year (in %)
 
Investment should be at least (in $)

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.