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Should You Use Index Funds or ETFs?

June 25, 2010

This week I got an email from a reader who is in the process of firing her advisor and becoming a Couch Potato. “I have decided it’s time to take matters into my own hands,” wrote Sarah. “I have $25,000 in mutual funds in my RRSP with my current adviser. I want to create a Couch Potato portfolio with ETFs, but I’m a little intimidated. I don’t even know how to set up a brokerage account.”

I surprised Sarah with my response: I suggested that she not open a discount brokerage account, and that she forget about ETFs for now. That’s because $25,000 is not enough to make ETFs efficient—index mutual funds are a much better option. The trading commissions Sarah would pay to buy and sell ETFs would outweigh the benefit of the lower annual fees. In fact, index mutual funds beat ETFs for most small portfolios.

I recently wrote an article in MoneySense about this issue, but I wasn’t able to go into detail about the math. Doing the calculations is important, though: choosing the wrong option can cost you a lot of money. If you’re considering your first Couch Potato portfolio and you’re not sure whether to use index funds or ETFs, here’s how to figure it out:

1. Determine the total MER of each portfolio option.

In general, ETFs have lower annual fees than index mutual funds, but the gap isn’t necessarily large, especially if you’re comparing ETFs to TD’s e-Series mutual funds. To determine the total MER of a portfolio, multiply the annual fee of each individual fund by the percentage you’ve allocated to that fund, then add them all up. For example, here are the calculations for two versions of the Global Couch Potato portfolio:

Index mutual fund % MER Weighted MER
TD Canadian Index – e 20% 0.31% 0.2 × 0.31 = 0.06%
TD US Index – e 20% 0.48% 0.2 × 0.48 = 0.10%
TD International Index – e 20% 0.50% 0.2 × 0.50 = 0.10%
TD Canadian Bond Index – e 40% 0.48% 0.4 × 0.48 = 0.19%
Total MER for portfolio
0.45%
Exchange-traded fund % MER Weighted MER
iShares S&P/TSX Composite (XIC) 20% 0.25% 0.2 × 0.25 = 0.05%
iShares S&P 500 (XSP) 20% 0.24% 0.2 × 0.24 = 0.05%
iShares MSCI EAFE (XIN) 20% 0.49% 0.2 × 0.49 + 0.05%
iShares DEX Universe Bond (XBB) 40% 0.30% 0.4 × 0.30 = 0.12%
Total MER for portfolio 0.32%

If you’re investing in only these four asset classes, the MERs are not dramatically different. The iShares version has an edge of just 0.13%.

2. Multiply the total MER by the value of your portfolio.

This step will determine your annual cost in dollar terms. We’ll use Sarah’s $25,000 portfolio value to make the comparison:

$25,000 × 0.45% with TD e-Series Funds = $112.50
$25,000 × 0.32% with iShares ETFs = $80

Turns out the difference in MERs works out to only $32.50 a year on Sarah’s portfolio. Fractions of a percent don’t add up to much in small portfolios. Had Sarah been investing $200,000, the difference between the two options would have been $260 a year and more of a concern.

3. Determine how many ETF trades you’d make annually.

At a minimum, count on making one trade per ETF each year. (If you make an annual lump-sum contribution and rebalance the portfolio at the same time, that’s as efficient as you can get.) Multiply the number of trades by the commission charged by your brokerage. For example:

4 trades with big-bank brokerage at $28.95 = $115.80
4 trades with low-cost brokerage at $9.95 = $39.80

4. Add the cost of the MER and the cost of the trades.

You need to consider both the annual MER and the trading commissions to determine the overall cost of your portfolio. Let’s compare the different versions of the Global Couch Potato portfolio at $25,000:

MER in Trades Cost of
MER dollars per year trading Total
TD e-Series Funds 0.45% $112.50 0 $0 $112.50
iShares ETFs @ $28.95 0.32% $80 4 $115.80 $195.80
iShares ETFs @ $9.95 0.32% $80 4 $39.80 $119.80

You’ll notice that for a $25,000 account, the total cost of maintaining the portfolio is less with the TD e-Series funds, despite the lower management fees of the ETFs. It’s a lot lower compared with the $28.95 trades, and even a few bucks less with super-cheap $9.95 trades.

5. Find the break-even point for the two options.

As your portfolio grows in size, the dollar cost of the MER goes up, but the cost of trades remains the same. That’s why ETFs are more cost-efficient in large portfolios. The trick is to find the break-even point. If your portfolio is more the break-even point, use the ETFs. If it’s lower, use the index mutual funds.

Here’s an illustration that assumes you’re comparing an ETF portfolio with a total MER that  is half that of comparable mutual funds, and that you’re making eight trades per year. In this case, let’s use a portfolio value of $75,000:

MER in Trades Cost of
MER dollars per year trading Total
Index mutual funds 0.60% $450 0 $0 $450
ETFs @ $28.95/trade 0.30% $225 8 $231.60 $456.60
ETFs @ $9.95 trade 0.30% $225 8 $79.60 $304.60

When comparing index funds with ETFs at a big-bank brokerage, $75,000 turns out to be the break-even point: the price difference between the two options is less than $7. (With the low-cost brokerage option, the break-even point is about $27,000, at which point the annual cost of the ETFs and index funds in this example is about $161.)

Keep the cost differences in perspective: in the above example, the low-cost brokerage would save you about $145 over the mutual funds, or 0.19% of a $75,000 portfolio. Those small savings come at the cost of flexibility: you can’t make monthly contributions with ETFs (unless you use Claymore’s PACC plan), and your dividends sit in cash until your annual rebalancing date.

While ETFs dominate almost every discussion of index investing (I’m guilty here, too), the fact is they are not cost-efficient for small portfolios. In Sarah’s case, at $28.95 per trade, her portfolio would have to be $86,000 before iShares ETFs were less expensive than TD e-Series Funds (assuming four trades per year). At $9.95 per trade, she would need only $35,000 to make ETFs cheaper. However, she would also be unable to make monthly contributions to each fund, something she does with her current RRSP.

There’s another factor to consider here: Sarah was nervous about even opening a discount brokerage account. With an ETF portfolio, she would need to be comfortable making her own trades, which is intimidating for many inexperienced investors. A couple of errors when entering orders would instantly wipe out any potential cost advantage of ETFs. And when investing makes you nervous, you’re liable to abandon your strategy, which is just about the worst thing you can do as a Couch Potato.

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13 comments

  1. Although several people have explained to me that it doesn’t make a difference, I still wonder if there might be long-term risk advantages for people who invest monthly as opposed to buying a whole bunch of shares just once a year. Over 12 years, you would be buying shares only 12 times with a once-a-year ETF strategy whereas if you bought shares every month you’d have 144 transactions.

    I get the feeling that with just 12 annual transactions, the odds that you could be hitting the market at the wrong time every time would be greater than if you had 144 transactions spread evenly over every year for 12 years. Of course the odds that you’d be hitting the market at the RIGHT time would be greater too, but it seems like more frequent investments would reduce your risk. Does this make sense?


    • Brad: What you’re describing is the whole idea behind dollar-cost averaging. There’s no easy answer to which strategy works best. If you make one lump-sum deposit in January, it does have the benefit of compounding for longer than if you spread it out over the next 12 months. I think most people invest monthly primarily because it’s easier on their cash flow, though it’s true that you may end up with fewer regrets.

      I found this article interesting:
      http://www.moneychimp.com/features/dollar_cost.htm


  2. […] investment @ MillionDollarJourney -Why asset allocation is so important @ GreenPandaTreeHouse -Should you use index funds or ETF’s? @ […]


  3. Great post. I would agree with you, certainly given your number-crunching evidence, creating an ETF portfolio is not very cost effective for any portfolio value under $35 K. If however, you manage to have household assets over $100 K, I know TD Waterhouse can group those accounts for you so your trading fees can be $9.95 instead of $29-ish.

    Regardless of what you pay in transaction fees, I think the most important factor (which you have correctly hit on) is if you’re an ETF investor, you’re a DIY investor. Holding any discount brokerage account, you would certainly need to be comfortable with your own transactions. That can be intimidating for many inexperienced investors.


  4. Another thing that isn’t mentioned is the tracking error and how that plays in mutual funds vs. ETFs. For instance, in your analysis, a sample situation shows the difference to be less than $7; however, the tracking error of the US/Int’l e-Fund offered by TD is much larger than the corresponding Vanguard ETF.

    It’s definetely something to consider when the tracking error of a mutual fund is off by 3-5% vs. the 0.2-0.8% tracking error of an ETF.


  5. […] advocate Ken Kivenko, there’s an interesting article at Canadian Couch Potato entitled Should you use index funds or ETFs? Click on the link for the full article, which I won’t attempt to reprise in depth […]


  6. “[with ETFs] your dividends sit in cash until your annual rebalancing date.”

    That depends on the ETF and broker – at TD Waterhouse, I’m able to have many of my ETF’s dividends DRIPped.

    On the other hand, typically with ETFs, even if you DRIP your dividends, you have to buy full shares, and as you reported today (http://canadiancouchpotato.com/2010/06/28/more-etfs-now-paying-monthly/), recent changes in how frequently ETFs pay their dividends may make this option a little less attractive to investors with smaller portfolios.


  7. While it’s true TD’s e-series is a better deal for smaller portfolios than iShares ETFs, you forget one vital piece of information. This woman is an investing neophyte. You’re simply transferring the advice from her advisor to a TD employee. That does little good in the long-run unless she is able to educate herself. If not, you’re just giving more money to the banks.


    • @Will: Sarah can open up her own e-Series account online and manage her own portfolio with no trailer fee. I’m not sure who the “TD employee” is that you’re referring to.


  8. Four well selected managed funds will out perform the above funds …because E_funds or index Funds can’t beat the market….but carry on


    • @DJ: You’re absolutely right: well-selected active funds would outperform the e-Series funds. There’s only one problem: they only appear “well selected” after the fact. The chances of choosing actively managed funds that will outperform index funds over a five-year period are perhaps one in 15 if you go by the SPIVA data. Over an investment lifetime the probability is extremely small.


  9. […] Should you use Index Funds or ETF’s asks the Canadian Couch Potato, which is a good query, I guess the one  you understand best is the best answer. […]



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