One of the most common arguments for investing in index funds is that they are low-cost, low maintenance, and their broad stock market exposure implies that you likely won’t sell them until you’re ready to retire.

On the flip-side, the worst-case scenario for taxes and fees are realized by those who day-trade in a non-tax shielded account. But how much of a difference is there really between these investment approaches? And what about trading on an occasional basis in low-cost Exchange Traded Funds (ETFs)? Is it reasonable to think that an average investor can trade every-so-often and exceed market gains by enough of a margin to counter any accrued fees and taxes?

To answer these questions, we’ve conducted a 10-year horizon case study to attempt and quantify the differences between a few investment approaches.

##### Case 1: The “Set It and Forget It” Index ETF Investor

For this case, we’ll use the Vanguard 500 Index Fund (VOO) as our benchmark. Since the ETF has not yet been in existence for 10 years, we’ll use the 10-year performance from its mutual fund equivalent, Vanguard 500 Index Fund Investor Class (VFINX). Based on this information, here are our assumptions:

- Fees: 0.05% annually, or $0.50 per $1000 invested
- 10-year average annual return: 7% (including any dividends)
- Assume a one-time $5/trade transaction fee

For the simplest case, let’s assume that we make an investment of $10,000 in a tax-shielded account such as an Individual Retirement Account (IRA). Let’s further assume for simplicity’s sake that the interest is compounded monthly. After 10 years, this investment would result in a total of $19,987. Not too bad – we more or less doubled our money.

##### Case 2: The Stock Day-Trader

We’ll assume that stock trading is our full-time job, and we’re really good at it – good enough to pull in a 35% gain per year. We also will assume that we don’t have specialized access to reduced transaction fees, so we’ll use a low-cost brokerage that anyone can access via the internet:

- No annual fees due to investment in stocks
- Annual return: 35% (including dividends)
- $5/trade transaction fee
- Conduct 2 trades per day

We’ll again assume an initial investment of $10,000 and, while it’s not the smartest thing to do with retirement funds, we’ll also assume that we’re doing this in a tax-shielded retirement account. Interest is again compounded monthly. After 10 years, believe it or not, * we’ve lost all of our money!!!* Surely we must have made a mistake in our calculations, right? Let’s think about it for a minute.

At 35%, after the first year we would have roughly made $3500 in gains. Pretty good! But then there are the fees. If we’re buying and selling a single stock every day, that’s $10/day in fees. Multiply that by 365 days… and you now see our problem. Our fee total of $3650 eclipses our $3500 in gains, and it gets worse each year as our balance dwindles. Talk about fees eating our lunch!

##### Case 3: The Market-Timing Specialty ETF Investor

In this case, we’ll assume that ETF trading is a part-time endeavor focusing on long-term gains with only a few trades per year. By successfully market-timing, this case results in annual returns of 10%. We’ll also assume the same low cost brokerage fees as the previous two cases:

- Fees: 0.35% annually, or $3.50 per $1000 invested
- Annual return: 10% (including dividends)
- $5/trade transaction fee
- Conduct 1 trade per 2 months

Assuming the same $10,000 initial investment, monthly compounding, and trades conducted in a tax-shielded account, after 10 years our portfolio is worth $25,645 . For the effort that we put in to track, research, and purchase specialty ETFs, we’re rewarded with gains of about $5600 (average of $560 per year) more than the “set it and forget it” investor.

Again, checking our math on this case helps to explain. We’ll pay $30 per year more in ETF fees and $30 per year more in transaction fees. However, at 10% we’ll gain approximately $1000 in the first year compared to only $700 in a broad market index fund. This equates to an overall gain of about $260 over the index fund case in the first year, and increases from there in the following years.

### Comparative Analysis

Here’s what these cases look like graphically:

One thing to note is, should you have a time-horizon greater than 10 years, the specialty ETF case will continue to exponentially out-grow the broad market index fund case. However, you need to ask yourself whether you have the time and desire to put in the work to get increased gains over such a long period. It would really help to understand how hard we really need to work!

We can gain some insight into the effort required by taking a closer look at the data. The first thing that’s rather obvious: the only annual return we’ve used that is based on historical data is the index fund case, so we’re going to leave that constant at 7%. Keeping with the rest of our assumptions, let’s first look at the day-trader case.

As we alter the annual return for this case, it’s clear that the gains are highly sensitive to a change in rate of return. To equal the returns of the index fund case over 10 years, we need only increase returns by 2.5 points to 37.5%. If we increase our returns by five percentage points to 40%, it results in a whopping $53,882 after 10 years! My sentiment is that it’s this potential for significant gains that attracts people to day-trading… but it’s also that risk and the high cost of trading that leaves many day-traders bankrupt.

Next, let’s analyze the specialty ETF case. Perhaps we believe that 10% is a little too much to expect from a strategy of this nature, especially if the market is down for a few years. So how much do we really need to “beat the market” by to recover our transaction and higher ETF fees?

Taking a look at the graph below, it’s clear that it doesn’t take much — only an increase of 0.5%! Surely it’s reasonable to expect we can do at least 0.5% better than a broad market index fund with a small time commitment each week.

*Note: it’s hard to see, but the Broad Market ETF (7%) and Specialty ETF (7.5%) curves are nearly on top of each other.*

### Effect of Taxes

Throughout this study, we assumed that all investments were done in a tax-shielded retirement account. What if you are looking to apply one of these strategies in a traditional brokerage account that is subject to taxes? Let’s briefly re-visit each case to show the impact of the dreaded tax man…

##### Case 1: The Index ETF Investor

Since this case does not result in a sale until the money is needed, taxes are minimized. The fund will likely provide dividends once per quarter, and based on VOO’s historical data we’ll assume that these dividends are $1/share at an average price of $150/share. The ETF is held for more than 60 days, resulting in “qualified dividends” that we’ll assume are taxed at a rate of 15% (tax rate is determined by your tax bracket).

This results in a total tax of approximately $800 and a balance of $19,206 after 10 years.

##### Case 2: The Day-Trader

As expected, taxes will be the most significant for this case.

With stocks being bought and sold every day, we’ll assume that all gains will be taxed at the short-term capital gains rate, which is currently equal to the ordinary annual income tax rate (we’ll assume an average rate of 25%). The overall effect of taxes means that a day-trader must now make average annual returns of 38.25% (up by 0.75%) to equal the performance of the index fund over 10 years after taxes. This case also lags the other cases for the entire 10-year period, but will exponentially exceed both of these cases past the 10-year time horizon at this rate.

##### Case 3: The Specialty ETF Investor

For these investments, it’s difficult to determine whether the ETFs will be sold within a year, resulting in short-term capital gains that are taxed as ordinary income, or sold after being held for longer than a year, resulting in long-term capital gains. For this analysis, we’ll assume a worst-case scenario where all profits are taxed as short-term capital gains with an average rate of 25%.

This results in a required average annual return of 9% (up by 1.5%) using this investing approach to equal the 10-year returns of the 7% index fund.

*Note: it’s hard to see, but the Broad Market ETF (7%) and Specialty ETF (9%) curves are nearly on top of each other.*

### Conclusion

Overall, the general belief that most people are best off placing their money in a broad market index fund holds true.

Most people don’t have the time, energy, and patience to study the market and make well-timed trades. If you are in this situation, I highly recommend you choose one or more broad market index ETFs and invest your money in it over time (better known as “dollar-cost averaging”).

It’s also readily apparent that day-trading is a really challenging endeavor. To make the required 38-40% average annual gains requires significant research and a * lot* of luck. While the rewards for reaching 40% gain are substantial, there is great risk for falling just a little bit short.

However, should you be interested in an opportunity to exceed broad market index fund gains with a little bit of research and dedication, a long-term specialty ETF approach could be profitable. With only a marginal fee above index funds (0.35% vs 0.05%) and a few trades per year at $5 per trade, the required gains are not much higher than the index fund case (0.5% – 1.5%).

*What approach do you take towards investing? How might you optimize the level of effort you place into investing to get the greatest “bang for your buck”? Finally, if you’re interested in pursuing a specialty ETF strategy of this nature, please sign up below for details!*

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