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ETFs: Schwab or Vanguard?

(MoneyWatch) Earlier this month, investment firm Charles Schwab (SCHW) announced that it had drastically lowered the expense ratios on its line of exchange traded funds. ETFs, as they're known in the trade, are index funds that trade on stock exchanges. I spoke to Schwab's managing director of ETFs, Eric Pollackov, who said that the company is committed to low cost ETF investing.

It's not a coincidence that the expense ratios for the firm's ETFs were all lower than what Vanguard offers and now sport the lowest expense ratios of any ETF, a distinction Schwab is quick to highlight. But perhaps the more important question is whether Schwab's ETFs are lower than Vanguard's offerings when it comes to total costs.

Which has lower costs?

ETFs have costs in addition to the expense ratio. There are commissions to buy the ETFs, bid-ask spreads, premiums and discounts, and tracking error from the underlying indexes. In short, it's a very complex subject. As far as commissions go, neither Schwab nor Vanguard charge commissions if traded in their respective brokerage accounts.

I asked Vanguard spokesman John Woerth whether the company had looked at some of these other expenses, and in response he provided me with the data below. Taking into account only bid-ask spread differentials and using the assumption of a one-year holding period, the three Vanguard funds came in at lower total costs than the Schwab funds. I asked Pollackov whether Schwab had done such a larger view analysis and he replied that it had nothing to release at this time.

Vanguard analysis

It seems logical that bid-ask spreads would be smaller at Vanguard, as they manage $221 billion of ETF assets while Schwab has only $7.5 billion. But this could change as Schwab ETFs grow, which would seem logical with their new lower cost structure.

In an effort to try to evaluate all costs, I crunched some Morningstar data to compare the performance of the Schwab Broad Market ETF (SCHB) to the Vanguard Total Stock ETF (VTI). Between 2010 through August 2012, the Schwab fund earned 34.2 percent, and the Vanguard fund earned 34.4 percent. Though both funds' expense ratios were virtually identical during this period, the Vanguard fund earned an extra 0.2029 percent.

This difference could be attributable to the fact that each ETF follows slightly different indexes. Yet it could also come from what is known as "tracking error," or the variance in actual performance from the index. The Vanguard fund holds 3,295 stocks, while the Schwab fund holds 1,925 stocks. Pollackov did confirm that Schwab's fund had some negative tracking error, but said it was less than 0.10 percent annually. Many index funds don't own every holding in an index and merely sample the holdings. This is called "index optimization," though I think the word "sampling" is more descriptive.

Finally, when it comes to international investing, Vanguard has one fund that owns the entire rest of the world, while it would take three Schwab funds to build similar diversification. The three Schwab funds have a lower weighted expense ratio but make the portfolio more complex.

And the winner is

I spoke to Matt Hougan, president of ETF Analytics at IndexUniverse, about the two ETF families. Hougan loved Schwab's announcement. He noted that he believes Schwab's actions were intended to be a loss-leader designed to bring in new accounts. Pollackov, however, said that Schwab expects to make money on their ETF business. Hougan agreed that Schwab is committed to low-cost index investing.

Though Hougan acknowledged that total costs between the two families are likely to be very close, he noted that it's similar to comparing two dollar stores selling all goods for 99 cents or 98 cents. It matters little because great low-cost portfolios can be developed using either products.

I also love this move by Schwab, as lower costs are always good for investors. I suspect Hougan is right in being a loss-leader. ETFs are hot. According to the Investment Company Institute, ETFs now total nearly $1.2 trillion in assets, growing by $106 billion over the past 12 months. Vanguard states that, according to Bloomberg data, about 40 percent of new money flowing into ETFs has gone to Vanguard so far this year. It makes sense that Schwab would want a bigger share and lowering costs should help.

My take is that the slight edge goes to Vanguard index mutual funds over both Schwab and Vanguard ETFs. Vanguard's mutual funds have an Admiral share class available with a $10,000 per fund minimum. This gives the same expense ratio as the Vanguard ETFs, but avoids the bid-ask spreads, premiums and discounts altogether because their structure is to always trade on net asset value. In addition, you can buy exact dollar amount of the mutual funds while ETF purchases are in whole number of shares.

I've been asked whether I think Schwab or Vanguard will be the ultimate winner in this price war.  I'm happy to say that I think it's the investor who will be the ultimate winner.

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