The weekend edition of the Globe and Mail carried a column by Noreen Rasbach, who is pondering a switch from mutual funds to ETFs, but is worried about the extra costs for small investors:
One of the downsides of ETFs is that they are bought and sold on exchanges, so you have to pay commissions, and it’s tough and expensive to do for people who set aside small amounts to invest each month.
While I am a huge fan of Exchange-Traded Funds (ETFs), it should be remembered that they are merely a tool to achieve an objective: to track broad stock market indexes at the lowest possible total cost. That objective can also be achieved by investing in index mutual funds. ETFs have lower MERs but investors pay a trading commission for each transaction. Index mutual funds, on the other hand, can be purchased in small amounts, typically without any fees but the MER is higher. A further advantage of mutual funds is that any distributions can be reinvested without any charge.
An investor just starting out can build a fairly diversified portfolio using just a few index mutual funds and can switch to an equivalent ETF after accumulating sufficient funds. One thumb rule that could be used to guide when to make the switch is to require the MER differential to pay for the trading commission within one year.
For instance, the TD e-Series Canadian Index Fund (TDB900) has a MER of 0.31% and the iShares CDN Composite Index Fund (XIC) has a MER of 0.25%. An investor paying $10 for each trade could make a switch after accumulating $16,700 in TDB900. Note that the switch can be made sooner if the MER differential is larger. The TD e-Series US Index Fund has a MER of 0.33% but the cheapest equivalent ETF costs just 0.09%, which would imply that the swap could be made with $4,200 (ignoring the cost of currency conversion).
Investors should also pay attention to the tax consequences of a swap: taxable accounts may take a capital gains hit when an index fund is sold to buy an ETF.
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11 responses so far ↓
1 Doug // Aug 11, 2008 at 6:18 am
I agree that cost associated with the Barclays Canadian stock ETF is lower than TD e-series Canadian stock index fund. This is especially true if you can get a DRIP on the ETF. However, I looked at the Barclays website, and the ETF makes distributions four times a year. If one is making a contribution once a year and reinvesting distributions four times a year and does this for several years, that is not a insignificant amount of record keeping to determine average cost. TD Waterhouse will not determine average cost, whereas the e-series will. I have taken the following from the Vanguard web site.
Features Vanguard Index Funds Vanguard ETFs
Investment approach Seek to closely track a benchmark using index management. Seek to closely track a benchmark using index management.
Buying and selling Directly from Vanguard. Through a brokerage service, such as Vanguard Brokerage Services®.**
Share price Net asset value (NAV) typically calculated at the close of each trading day. Fluctuating market prices throughout the trading day.
Trading flexibility Transactions processed at next closing NAV. Buy and sell at any time during the trading day with the ability to use stock-trading techniques.†
Operating expenses Low operating expenses as a result of index tracking. Lower operating expenses than corresponding index funds.
Trading costs None.†† Brokerage commissions and bid-ask spreads charged each time you buy or sell ETFs.
Potential for tax efficiency Potential for high tax efficiency due to low turnover resulting from index management. Potential for high tax efficiency due to low turnover resulting from index management.
Reinvestment options Provided by Vanguard. Availability and cost depend on broker.
Client services Provided by Vanguard. Provided by broker.
Average cost statement Provided by Vanguard. Provided by broker.
2 Phil S // Aug 11, 2008 at 7:29 am
Another option is to use leverage to achieve your means. If you are making small monthly contributions, why not use leverage in a line of credit to make a lump sum purchase of, let’s say, $10K in your ETF. Then use your small weekly or monthly contributions to pay down your leverage? In that way, you minimize your trading commission AND you also get a tax deduction from the interest on the amount you took out of your line of credit. Then, as the expression goes, Bob’s your Uncle!
3 WhereDoesAllMyMoneyGo.com // Aug 11, 2008 at 10:24 am
Excellent post CC. There was some material that did not make it to the article (space constraints I’m guessing), but we did chat about a possible misconception that people have about ETFs and passive indexing - such that ETFs vs Fund Trusts are just structural - the decision to be passive or active can be made within each structure.
Also, regarding cost base - I agree that if you aren’t diligently managing the accounting of the transactions, it can be daunting to go back and figure it out. But like with many things, it’s a matter of setting up a routine and keeping on top of it (the math is simple). The cost adds up and then add compounding and the decision becomes less trivial over time. Again, it’s not that hard do to as long as you keep all your records in order.
4 Charles // Aug 11, 2008 at 10:56 am
Doug, Vanguard’s index mutual funds are excellent low-fee vehicles… that are *only available in the US*. Americans have access to lots of funds that are much more competitive in MER than in Canada.
As for keeping track of cost base… yes, record-keeping is necessary. This is the price of complicated tax laws. If you’re not willing to shell out for a copy of Quicken, a properly-designed spreadsheet would do the trick.
5 Canadian Capitalist // Aug 11, 2008 at 11:26 am
Doug: I don’t understand why TD Waterhouse will keep track of average cost for the e-Series funds but not for ETFs. I hold both in my personal Waterhouse accounts and the book value is kept track of for all the holdings. Even when I transferred accounts from one broker to another, the book values got ported correctly.
In any case, this isn’t a huge concern. It is a simple matter of recording transactions every quarter or so.
6 larry macdonald // Aug 11, 2008 at 11:15 pm
I wonder if one thing to consider in the switch from mutual funds to exchange traded funds (and index fund like TD eFunds) is that mutual funds are often sold as part of a financial planning package that includes tax, retirement, estate, children’s education, etc planning. Ostensibly, these ancillary services are provided at no charge but payment in fact occurs through the management expense ratio. Anyone switching to ETFs would likely have to give-up these “free” ancillary services and spend time/effort self-educating/managing these aspect of their finances (or else hire an advisor to handle them). Either way, it’s a cost that perhaps should also be considered in the discussion about switching from mutual funds to ETFs and index funds?
7 Forone // Aug 12, 2008 at 12:28 pm
Here is a nifty calculator for mutual fund fee costs over several variables (ETF costs can be estimated by adding the total brokerage fees as “other fees” at the bottom)
http://www.investored.ca/IefCalculators/Calculators/MutualFundFeeImpact/default.aspx
8 A Lap Of The Blogs : WhereDoesAllMyMoneyGo.com // Aug 14, 2008 at 10:06 pm
[...] Canadian Capitalist reminds us that you don’t have to use ETFs to track indices, you can use mutual funds to do that as well. (Make sure to check out the article he references in the Globe - it’s bloody [...]
9 Rusty // Aug 14, 2008 at 10:20 pm
I’m not following the math… how many $10 trades per year are there?
10 EnRock // Aug 15, 2008 at 12:34 pm
This is a great reminder that its not the vehicle that matters, but what’s inside that counts. Investors should use all the available tools, including ETF’s and mutual funds, in order to maximize expected return, minimize risk, and REDUCE FEES.
You can see a table I created of average annual costs for ETF’s vs Mutual funds that I use to help decide where to invest my money at http://enrock.net/2008/02/08/should-i-buy-a-mutual-fund-or-an-etf/
11 Canadian Capitalist // Aug 15, 2008 at 1:12 pm
Larry: TD e-Series mutual funds is directly comparable to ETFs because the mutual fund is sold online and cannot be purchased at a local TD Branch.
Forone: Thanks for the link. One of these days, I’ll get around to organizing all the great links I get from all of you.
Rusty: There are two trades — one to sell the mutual fund (typically no fee if it has been held for 90 days) and one to buy the equivalent ETF. The MER savings is = amount invested * MER differential. When this equals the commission paid for buying the ETF, a switch can be made.
EnRock: As a portfolio grows larger, it is possible to give up on mutual funds altogether and buy ETFs directly. Regular savings can be accumulated as cash in the portfolio and once it becomes a decent stash used to purchase an ETF. (Nice blog, BTW).
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