A popular question from investors convinced of the merits of passive investing is: at what portfolio size does it make sense to use Exchange-Traded Funds (ETFs) instead of index mutual funds? While ETFs typically have a lower MER and hence are cheaper to own, it costs trading commissions (and foreign exchange fees for some ETFs) to buy and sell, which could simply overwhelm any MER savings. For instance, it wouldn’t make much sense to pay $30 to buy $200 worth of iShares CDN LargeCap 60 Index Fund (TSX: XIU) but you can buy index mutual funds such as the TD e-Series funds for as little as $100 (or even $25 for pre-authorized purchase plans).

Unfortunately, it is not possible to give a clear cut answer to the question about portfolio size because it depends on a number of variables such as the commissions charged, the frequency of buying and selling, the growth rate of investments etc. One simple thumb rule that I use is that the MER savings from owning ETFs should cover the initial trading commissions in one year.

Size of portfolio for choosing ETFs = Trading commissions / (Higher MER – Lower MER)

Take the Sleepy Mini Portfolio, which is invested in four TD e-Series mutual funds and has a blended MER of 0.401%. The equivalent ETF portfolio would comprise of XBB, XIC, VTI and VEA and would have a blended MER of 0.167%. If your brokerage charges $30 per trade and you invest a lump-sum once every year and you ignore any foreign currency conversion charges and no fees are charged for selling, the thumb rule indicates that when the portfolio is over $51,000, it makes sense to switch the Sleepy Mini holdings to ETFs.

Of course, ignoring foreign currency conversion charges, which typically costs about 1%, does not result in a very accurate estimate. If you want to account for foreign conversion fees, you’ll need to solve for the following equation (assume size of portfolio for choosing ETFs is x and foreign exchange fees are amortized over y years):

(MER difference) * x = trading commissions + (portion in foreign stocks * x * foreign exchange conversion fee) / y

For the Sleepy Mini Portfolio, which has 60% in foreign stocks, assuming foreign exchange fees cost 1% and are amortized over 5 years and trading commissions cost $120 per year, x works out to $143,000.

If this math makes your head hurt, rest assured that it is only a very rough estimate as savings from holding ETFs accrue over the entire holding period, not just the first year. Then, you need to make assumptions about the growth rate of the investments and even then all you have is a more refined estimate. The Sleepy Portfolio, which is valued around $100,000 holds ETFs and the Sleepy Mini portfolio, which is a modest portfolio to which $1,000 is added every quarter holds TD e-Series mutual funds. In our personal portfolios, I follow the same rough guideline. Portfolios that are larger than $50,000 are implemented using ETFs. Modest portfolios, such as our kids’ RESPs are implemented using index mutual funds.

This article has 27 comments

  1. For a portfolio that you plan to build over time, diversification when you are just starting out is not very important. For example, if you have $10k in retirement funds, and you plan to add several times that amount over time, there is nothing wrong with putting the whole $10k into just one index, such as XIC. When you have more to add, the next purchase could be bonds (XBB), or one of the other ETFs you mentioned (VTI or VEA). Using this approach, the threshold where it makes sense to use index ETFs rather than index funds is far lower.

  2. Just wanted to say that I find your posts incredibly helpful. Far more useful than the advice one would pay to receive!

  3. I’ve often wondered when it’s time for a DIY investor to make the switch from Index Funds to ETFs. I love the mathy math.

  4. Charles in Vancouver

    I use ETFs for lump-sum purchases that are “past the threshold”, and TD eFunds for small amounts I buy during the year. Eventually when any eFund gets big enough I can buy a lump of ETF with it.

  5. In my opinion, give small wait to Index fund by considering the fund manager style. A small amount of systematic investment will be enough in Index fund. The second option is start buying ETF using DCA (Dollar cost average) methods to invest regularly and systematically, will do better. Single huge investment in ETF always better when the stock markets are maximum down.


  6. There is another cost when using index ETFs. You have to determine adjusted cost base, and you won’t be getting yearly T slips.

  7. Doug, I believe all companies that generate some sort of taxable activity (capital gains, dividend income or other income) are required to send out T slips to investors holding the investment in taxable accounts. As for ACB your brokerage account may keep track of that for you but at the very least you should get a statement every time you buy or sell. Every responsible investor should keep track of their paperwork and therefore be able th calculate their ACB.

  8. I’ve written about 50 (boring/pointless) posts trying to figure out this question.

    My best answer is stick with index funds forever for the convenience unless you are a super keen investor in which case you will probably figure out the proper time to switch yourself.

    Michael James – I’ve been meaning to post about that exact idea. The way I look at it if your contributions are a significant percentage of your portfolio then you can count near-term future contributions as part of your current allocation.

  9. FP – or until td raises the mer on their efunds. I hope that doesn’t happen anytime soon.

  10. Canadian Capitalist

    @Michael: If we are talking about investments within a taxable account, your point has the additional merit of avoiding an unnecessary taxable event in the future. But if switching doesn’t have tax implications such as within RRSPs, RESPs etc., I’d still go with starting out with a diversified mutual fund portfolio and switch after the portfolio gets to a certain size.

  11. For myself personally, my threshold came when my portfolio size hit the $100K mark in total assets. But that is mainly because that was when my trading commissions dropped from $29.95 per transaction down to $9.95 per transaction. But in my case, I went from mutual funds to direct purchase of stocks and bonds, not to ETFs.

    These days, there are alternatives like Questrade where the threshold is not nearly so high as at BMO Investorline. I suspect that if I were a new investor today, I would start trading much earlier than I did as compared to when I was younger.

  12. “Size of portfolio for choosing ETFs = Trading commissions / (Higher MER – Lower MER)”

    What do you mean Higher MER-Lower MER?

    Do you mean the average of all MERs?

  13. Sorry to muddy the waters, but don’t forget Claymore ETFs also now allow you to setup a pre-authorized purchase plan commission free. This helps reduce fees a bit, but their average management fee of 0.65% is still higher then either iShare’s ETFs or TD’s e-Series.

  14. What about the cost of the bid/ask spread for index ETFs? It’s small, but it is there.

    • Canadian Capitalist

      @Doug: To be fair, mutual funds have commissions and bid-ask spreads to contend with as well. It is not broken out as a separate line item but shows up in the tracking error.

      @Jordan: Yes, Claymore ETFs muddy the waters a lot. Compared strictly on MER basis, TD e-Series funds are cheaper but then Claymore tracks more expensive fundamental indices.

      @J Lin: No, I mean the difference in MERs between ETFs and mutual funds.

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  16. It’s interesting to see that the breakeven could be pretty high – for someone starting out it could be 5-10 years or more before ETFs become a practical choice. Of course you can always switch from investing monthly to doing it 2-4 times per year. Over the long term it wouldn’t make much of a difference and could cut down the commissions a lot. In that case it might make sense to switch around $30,000 if the investments are large enough.

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  19. I think your math’s wrong. MERs are expressed not in percentages, but in percentages per year. The right formula would be:

    Size of portfolio for choosing ETFs = Trading commissions / (Higher MER – Lower MER) / Years invested

    “Years Invested” is how long you expect to be in this ETF before moving your money elsewhere and incurring more commissions.

    If you expect to stay invested for, say, 10 years, then your Sleepy Mini example (without currency conversion charges) works out to $5100, a much more reasonable number.

  20. Canadian Capitalist

    “One simple thumb rule that I use is that the MER savings from owning ETFs should cover the initial trading commissions in one year.”

    Patrick: Perhaps you missed that I want to make up the MER savings in one year. Even if you can estimate correctly how long you are going to own an ETF instead of a mutual fund, you still need to factor in growth to get an accurate estimate.

    Starting out with e-Series funds is a great choice and investors can always switch out when the portfolio becomes larger. Of course, in taxable portfolios, it may be better to start out with ETFs as others have pointed out here.

  21. @CC: Yes I guess I did miss that. It does seem to make your results less useful though. What is the practical purpose of making up the commissions in one year? I thought we were trying to minimize our costs.

  22. Canadian Capitalist

    @Patrick: I use the one year thumb rule because I’m assuming 1 buy of each ETF initially and rebalanced annually. So, let’s say MER differences are ‘delta’. Holdings are over ‘y’ years. And trading commissions are ‘tc’ and ‘x’ the size of the portfolio. The equation works out to:

    x * delta * y = tc * y

    x = tc / delta.

    I’m basically assuming that this is not a one shot buy and trading commissions are incurred to rebalance every year thereafter.

  23. @CC: Ok, I see where you’re coming from. I think we were comparing apples and oranges. You’re looking at one lump sum, rebalanced annually. I’m looking at what to do with periodic contributions.

  24. how much does questrade cost to trade ETFs?

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