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Wednesday, 17 September 2008

Vanguard Too Expensive?

I invest in a mutual fund from Vanguard Australia. Vanguard loves to talk about how cheap its index funds are. They are right in that their index funds are cheap compared to mutual funds from big, well-known companies like Colonial First State. The problem is that they aren't cheap compared to direct share ownership or ETFs. Vanguard in the US provides ETFs, but Vanguard Australia doesn't. Vanguard Australia's MERs are also quite high. I pay 0.9 per cent per year. I am starting to believe that if I purchase shares directly I can replicate the broad market myself while paying zero management fees.

Some people argue that DIY indexing is more expensive because, for example, if you wanted to replicate the S&P500 (probably the most replicated index in the world) you would have to buy shares in 500 different companies and you would have to constantly buy and sell as companies go in and out of the index. The whole idea of indexing is that you follow an index. What makes one index better than another? For example, you could use the S&P500, but you could also use the Dow Jones Industrial Average (DJIA). In Australia, you could use the S&P/ASX 200 but you could also use the S&P/ASX 300 or even the broader All Ordinaries. Who ever said that 200, 300, or 500 is a sacred cut-off number? If you hold 500 companies, in reality if you added 100 more there wouldn't be much difference because each marginal company you add has a relatively small market capitalization. At some point you are overdiversified. If there is no such thing as overdiversification, then why do indexers only hold the top 500 or top 200 companies in a country? Why not hold every single company in the country or the world? I think that holding the top 20 companies is enough, but if you want to go further you can easily, and the costs will be lower if you held them directly. I think that if you factor in costs of diversification you can use calculus to derive the optimal number of companies to hold. William Bernstein claims that the best option is to hold "every single company" but I doubt he actually holds every single company in the world. If you're an indexer, you hold an index, which is a selection of companies.

Of course, companies change. Some top performers fall from grace. For example, Enron collapsed. If a certain company falls from an index, the index fund manager will sell the shares. The DIY indexer can do the same.

I happen to think that minimizing cost is more important than strictly following an index. Strictly following an index I think is quite dogmatic. I recommend buying randomly using the top companies (using market cap as weights) and then every now and then superimpose the performance of your portfolio onto to the index to see if it roughly matches. You could use statistical techniques but I think just eyeballing is enough. By doing it yourself you pay zero management fees. Vanguard argues that costs matter. If you believe them, you should ditch them.

It is true that you pay brokerage fees for buying stocks directly but you must also remember that Vanguard has a buy spread. As long as you're not putting in small amount all the time, you should be okay.

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