The Vanguard Catch-22

As I’ve mentioned many times before, all of my taxable investing, as well as my Roth IRA, is done directly through Vanguard.

I use Vanguard because I trust them – they’re a nonprofit that has a stellar long-term record and their index fund investment options are quite strong. I’m not alone in feeling this way – for example, Paul Farrell, in his book The Lazy Person’s Guide to Investing (read my review) states the following on page 167 of the paperback:

Specifically, Vanguard’s no-load index funds hav become the benchmark and the standard against which every other fund, index or active, and all fund families are measured. They are the proverbial pain in the [rear] for the vast majority of their competition in the mutual fund industry.

… and that’s after the quote from the other day where Farrell said “Bottom line: if you want predictable performance, pick cheap funds. That means no-load index funds.”

In a nutshell, if you’re looking for a place to sock away your money for the long term (more than five years, at least), Vanguard is a great place to put it.

There’s only one problem: most of the funds that Vanguard offers have a $3,000 minimum for investing. For a lot of people just getting started, that’s a hard minimum investment to swallow. A lot of people want to get started with just $50 a month or so – with that amount, it’d take 60 months – five years – to build up the minimum just to buy in. That’s a long wait.

So what are the options? Let’s look at a few of them.

Save up the cash in a savings account. This is the method I used when saving up for my first fund purchase. Since I use ING Direct for my primary checking and savings, I just set up a sub-account specifically for that purpose, then I set up an automatic transfer of a small amount into that account each week. Then I just sat back and waited, using the interest on that account as a bit of wind in my sails.

The “save up cash in a savings account” option has the advantage that your money will slowly grow over time as you save towards the goal – it’s not at risk at all.

Invest in another fund. There are similar index funds to the Vanguard offerings sold by other investment houses, often with lower minimum investments required. However, in almost every case, these funds have a higher expense ratio – meaning that the investment house skims more off the top for the investment. For example, the Vanguard 500 (VFINX), which matches the stocks held in the S&P 500, has an expense ratio of 0.18% – over the course of a year, for every $1,000 you have in that fund, Vanguard uses $1.80 for the expense of managing the fund. Many other similar funds to the Vanguard 500 at other houses have expense ratios at 0.5% or above – for every $1,000 in that fund, the company uses $5 for fund management.

While there are deals out there if you dig for them (and I’m pretty much expecting someone to find a fund with a competitive expense ratio and then comment about it), Vanguard’s funds are easy because they’re so consistent across the board. They’re always among the cheapest.

Buy an ETF through a brokerage. Another popular option is to just buy a very similar ETF through a brokerage. For those unaware, an ETF is an exchange traded fund – basically, it functions like a single stock that matches the value of a particular index. A specific example is the Spider ETF, which matches the S&P 500 in much the same way that the Vanguard 500 does.

There are some big benefits to this. You only have to match whatever minimums your brokerage sets out for you, and these are usually quite low. Their expense ratio is usually very low – Spider’s expenses are lower than the Vanguard 500. Plus, if you use a fee-free brokerage like Zecco, you don’t have to pay any commissions on buying and selling.

However, in the end, they’re still not the best deal. For starters, ETFs hold onto your dividends for quite a while, whereas funds pay out dividends quite quickly. There can be as much as a three month difference between the two, and if you’re reinvesting, that alone can easily make up the tiny difference in expense ratios. Plus, when you buy in, you effectively have to pay a small premium on the value (the bid-ask spread) in order to find someone selling that ETF – for Spider, this is usually around 0.07%. If you’re using a brokerage that charges fees, that’s another extra cost – investing directly with Vanguard doesn’t cost a dime. These make up the difference and more, making ETFs a slightly worse deal than investing directly in funds.

My recommendation? Set up a savings account and start saving your nickels and dimes. With a little patience, you’ll be there in no time and then you can buy into an excellent fund.

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