Making this switch can pay off in several ways

The Lowdown on Converting Vanguard Mutual Funds to ETFs

A growing number of mutual fund investors are wondering whether it makes sense to trade their mutual funds in for exchange-traded funds (ETFs). After all, making that switch has many advantages, including intraday liquidity, lower tax liabilities and lower annual expense ratios.

What about shareholders in Vanguards index mutual funds? Is it best to convert those mutual fund shares to Vanguard ETFs that track them same index or not?

Heres the lowdown on conversions from Vanguard mutual funds to Vanguard ETFs:

Fees for Converting

Shareholders of Vanguard stock index funds that offer Vanguard ETFs may convert their conventional shares to Vanguard ETFs of the same fund. For instance, a shareholder who owns the Vanguard Total Stock Mkt Idx Inv (MUTF:VTSMX ) could convert to the Vanguard Total Stock Market ETF (NYSE:VTI ).

Vanguard Brokerage clients incur no fee to convert conventional shares to Vanguard ETFs of the same fund. but other brokerage providers may charge such a fee.

Tax Consequences

When you convert from the Vanguard mutual fund shares to Vanguard ETFs, the conversion is generally tax-free. When might there be a possible tax? Some brokerage firms may be unable to convert fractional mutual fund shares, which could result in a potential taxable gain.

Conversion Limits

Four of Vanguards bond ETFs the Vanguard Total Bond Market ETF (NYSE:BND ), Vanguard Short-Term Bond ETF (NYSE:BSV ), Vanguard Intermediate-Term Bond ETF (NYSE:BIV ) and Vanguard Long-Term Bond ETF (NYSE:BLV ) do not allow the conversion of bond index fund shares to bond ETF shares of the same fund. However, the other eight Vanguard bond ETFs allow conversions.

Also keep in mind that your share class conversions are irrevocable. Once you convert from conventional shares to Vanguard ETFs, you cannot convert back to conventional shares. Conventional shares held through a 401(k) account cannot be converted to Vanguard ETFs.

Other Considerations

For cost-sensitive investors, the low fees in Vanguard ETFs are hard to beat. The Vanguard Emerging Mkts Stock Idx (MUTF:VEIEX ) charges annual expenses of 0.35%, compared to the Vanguard MSCI Emerging Markets ETF (NYSE:VWO ), which charges just 0.22%. At face value, these cost differences may seem small, but they add up over the years.

Another advantage of the Vanguard ETF share class is no onerous redemption charges. VEIEX charges a purchase fee of 0.25% and a redemption fee of 0.25%, whereas buying VWO incurs only a brokerage commission charge. And if Vanguard holds your brokerage account,  it doesn’t charge commissions for trading VWO.

While I deeply admire John Bogle, Vanguards founder, I do not share his radical view that ETFs are a substandard or faulty choice. ETFs are a contemporary extension of the indexing trend he started in the 1970s.

Personally, I think the ETF share class offers Vanguard investors much more flexibility. Assuming your Vanguard ETFs have underlying options, you can hedge your ETF shares with put options or sell covered calls to generate additional monthly income. You cannot execute these strategies with Vanguards mutual fund share class.

Lastly, when it comes to selling your ETF shares, you can determine the price you at which you want to sell them by placing limit orders. You cannot do this with mutual funds because you never know the exact price at which your mutual fund trades are going to settle its determined by the funds net asset value (NAV), which is calculated by the fund company after the market closes.

This article is brought to you by ETFguide.com. ETFguide is the information leader on exchange traded funds because of its vendor-neutral approach and its progressive reporting style. Unique features include an ETF bookstore, a monthly e-mail newsletter, and subscription based ETF portfolios.

Ron DeLegge is the Editor of ETFguide.com and Author of Gents with No Cents:A Closer Look at Wall Street, its Customers, Financial Regulators, and the Media (Half Full Publishing, 2011).