ETFs vs open ended mutual funds

You absolutely can use specific share basis accounting with open-end mutual funds. However, you need to have the fundco send you written confirmation of your designation. I don't know what other brokerages are doing, but Fidelity is wonderful at tracking basis and letting you place specific share sell orders online, for both exchange traded securities and open-end funds.

Depending how VTI is actually structured, it can be. The thing that a properly-structured ETF saves you from is waves of cap gain distributions caused by heavy redemptions.

Lets say an ETF and a similar open-end fund have been having great years -- lots of unrealized gains in the fund's holdings.

Now some bad news comes along and investors panic and want to get out.

When open-end fund investors cash out, the fund itself has to come up with the cash to pay them. If enough people want out, the fund may have to liquidate a significant amount of its holdings and if it has lots of low-basis holdings, that's going to mean big cap gain distributions paid out to the remaining shareholders.

By contrast, the ETF investors are simply selling their shares to some other investor. The fund isn't involved at all, so no need to sell holdings to raise cash to meet redemptions. And if a big investor wants to redeem his holdings, ETFs pretty much all say that redemption is in kind. The big shareholder turns in his ETF shares and receives a basket of the fund's actual holdings. This is a tax-free exchange for the fund (and the investor), so the fund does not realize any cap gains and so no cap gains to distribute to shareholders due to the redemption.

Sadly, to my knowledge, Vanguard isn't doing this. Also, Fidelity's Spartan Total Market Index Fund comes in at 0.1%, which beats both VTSMX and VTI. It's very attractive.

But I can't help but think back to not long ago when Fidelity still sold load funds and had a 0.5% ER on index funds... and since there's a good chance that FSTMX is losing money for the company, I'm avoiding them for taxable accounts in case they backslide.

Although, I wonder if VTSMX and FSTMX would be considered like-kind or in-kind investments? It would be nice to switch without tax ramifications.

This is a good point, and it seems as if VTI would work as you described. On the other hand, it might have to pay out if investors bail from the underlying fund. (Can't find much evidence of a bail during earlier bad times, but past performance is not an indication of, etc... .)

There are two aspects here - one is the ability to place (and have Fidelity acknowledge) specifice share orders, and the other is for Fidelity to track this correctly. Fidelity is, as you said, great at the first.

However, their system can get fouled up on the latter. If you sell specific shares before telling the system that you are switching from average cost to specific shares (FIFO if shares not indicated), their system gets confused about costs and doesn't seem to ever recover. Also, if you tell it you are using specific shares/FIFO, then it can never be switched to average cost (even though this would be legal).

This was a complaint that many made when Fidelity originally reduced their expense ratio. I was one of the complainers, because I'd watched them in the past convert their low cost Spartan 500 index into a higher cost, non-Spartan fund, and back again. In response (not to me, but to places like M* :-), Fidelity made the reduction "permanent" (or at least as permanent as one can write into a fund). So I'm not particularly worried about their index fund expenses - except for International, where they wrote a 0.20% "permanent" expense into the fund, and not the 0.10% that they are currently charging. (0.20% is still low, but the 0.10% is IMHO hype.)

Vanguard (and pretty much any fund) can force large redemptions to be taken in kind also. Further, because VTI is simply a different share class of VTSMX, the open end shares supposedly inherit some of the benefit of ETFs.

"Vanguard reserves the right to pay all or part of a redemption in kind ... if we reasonably believe that a cash redemption would disrupt the fund's operation or performance ..." Prospectus, p. 53.

"With [Vanguard ETFs], investors in both the traditional fund share class and ETF share class reap the tax efficiency created by ETF class (because everyone's money is pooled together in the fund).

040129 Note that VTSMX (and its sibling share class VTI) track a different index from most other total stock market funds.

Finally, if you do invest in VTSMX, you have the option (assuming that your broker can handle this properly - not all do) of converting your VTSMX shares to VTI shares as a non-taxable event. There is a broker fee for this service (VBS - Vanguard Brokerage Services - charges $50). This gives you a way of starting out with the open end shares and if you have buyer's remorse, changing later without tax consequences.

"Vanguard ETF Shares") FWIW, if I had an account at Fidelity, I'd use Fidelity's index fund; likewise at Vanguard, I'd use VTSMX. With high enough balances, one can convert to cheaper Admiral (Vanguard) or Advantage (Fidelity) shares.

Mark Freeland snipped-for-privacy@sbcglobal.net