Couch Potato Basics, Part 1: Low Costs

January 10, 2010

This post is the first in a five-part series outlining the primary benefits of the Couch Potato strategy.

Mutual funds are a great investment tool—in theory. They allow small investors to pool their money and buy stocks and bonds that would be far too expensive to purchase individually. They’re managed by professionals who—presumably—use strategies that are more sophisticated than those the average investor could employ. No wonder so many Canadians own them.

Unfortunately, mutual funds have a fatal flaw: they’re too expensive. Especially in Canada.

Equity mutual funds offered by the big banks typically charge 2% to 2.5% in management fees, often considerably more. Fund companies that sell their products directly to investors—such as Phillips Hager & North, Beutel Goodman and Mawer—charge lower fees, but 1.2% to 1.5% is still typical.

Canadians, in fact, pay the highest fund fees in the world: a recent report by Morningstar graded fund expenses in 16 countries and gave Canada the only F. “Canadian investors are comfortable with the fees,” the report says, “because they don’t know how low these fees should actually be.” Now doesn’t that make you feel like a chump? You can almost hear your advisor snickering.

Even index funds in Canada are too expensive, given that it takes no special talent to manage one. In the US, where investors are far more sensitive to costs, companies such as Vanguard, Fidelity, Charles Schwab and T. Rowe Price offer index funds with annual fees under 0.20%. By contrast, CIBC and BMO charge over 1% for all of their index funds. Even the reasonable costs of index funds managed by TD, RBC and Altamira (between 0.50% and 0.70%) would be considered absurdly overpriced in the US.

That’s why ETFs are such a game-changer: Canadian investors are starting to ask their advisors why they should pay 2.5% for a large-cap mutual fund when they can buy the iShares Canadian Large Cap 60 Index Fund (XIU) for 0.17%. What’s more, although Canadians can’t buy the super-cheap mutual funds available to Americans, we can buy US-listed exchange-traded funds. The Vanguard Total Stock Market ETF (VTI), for example, holds more than 3,300 US stocks and charges a microscopic 0.09%. That’s just $9 annually on a $10,000 investment.

Using only ETFs, it’s possible to build an extremely well diversified portfolio for under 0.25% in fees. (We have several suggestions on the Model Portfolios page.) That’s about one-tenth the cost of a similar portfolio of mutual funds.

Make no mistake: saving 2% annually in fees can make the difference between success and failure in investing. If you put $300 a month into an RRSP for 30 years and earn 7% annually, the money would grow to $368,000. Subtract 2% per year, and your nest egg shrinks to $250,000. That’s right: a 2% annual fee can cost you one-third of your retirement savings.

Part 2: Pure asset allocation

Part 3: Transparency

Part 4: Flexibility

{ 7 comments… read them below or add one }

Doctor Stock January 18, 2010 at 2:51 pm

1st time here… interesting. I’ll be back!

Steve Zussino January 18, 2010 at 3:34 pm

Great article!

I love that stat that shows what a 2% difference makes over 30 years.

Ashley May January 25, 2010 at 12:45 am

Hi there,

I have recently started taking a much more active interest in my investment portfolio. After I discovered how much the MER on my mutual funds can cost me over the long run – and how cleverly they are hidden in the fund itself – I was a little choked. The good news – I am 29, and have a very long horizon ahead of me, so now is the ideal time to learn and switch things up.

Periodic investing has worked well for me because it’s so easy – I don’t have to do anything. I want to shift my investments to index funds, but here’s the problem: I don’t want to pay the high MERs for my growing portfolio (which currently doesn’t have index funds, yet…), but ETFs are not practical for periodic investing only because the brokerage fee on $250 invested bi-weekly would negate the cost savings. So here’s my solution – move my existing portfolio to indexed ETFs, and continue periodic investments in indexed mutuals until there is sufficient capital to convert to an ETF that the brokerage fee is less than an MER on mutual funds. I hope to God that made sense.

National Bank Securities (my current provider of mutual funds) offers only a handful of index funds, some with MERs above 1%, and many of which don’t even track broad based indices. Here’s my question: what are the best alternatives to National Bank Securites that a) offer a variety of indexed mutual funds, with b) MERs that are more reasonable than 1%, and c) that track indices that are more broadly-based than the Dow (like the S&P 500, Russel, or anything with total market exposure)?

Any suggestions for fund dealers would be appreciated. Thanks!

Canadian Couch Potato January 25, 2010 at 8:40 am

Ashley: You’re definitely right to recognize that ETFs are a poor choice for biweekly or monthly investors. Your plan to contribute to index mutual funds until you’ve saved enough to buy ETFs is a perfectly good solution. Do the math to figure out at what point the ETF trading commission is offset by the lower MER and go from there.

You could also look at Claymore’s preauthorized cash contribution (PACC) plan, which does allow you regularly purchase ETFs each month without trading commissions, so long as your brokerage allows it:
http://www.claymoreinvestments.ca/etf/investment-services/pacc/

National Bank owns Altamira, which offers several very inexpensive index funds with broad market exposure (see the Canadian Index Funds page on this blog). All discount brokers offer wide access to index funds from other providers, but if you’re opening a new account, consider TD Waterhouse so you can access their e-Series funds, the cheapest in Canada.

Zmiles May 14, 2012 at 12:45 pm

The return generally reported on a fund reflects the “after fees return”. Therefore the MER does NOT reduce the return that is reported. The article above suggests that a 2% MER has a significant negative impact on the growth of your fund investment. Not true. However, beyond management expenses related to running the fund, part of the MER is destined as a trailer fee to the Financial Planner for his “expert” advice and service. It is not unreasonable to have pay for the Financial Planners advice and service if you require it. You cannot expect it for free. However, caveat emptor! I conclude that for a fund to deliver a return to match an appropriate index, the fund would have to have a gross return at least equal to the index return + the funds MER. This should be expected based on the active management and selection of investments by experts…..but is seldom the case!

Kevin November 18, 2013 at 8:48 pm

@CCP

In your opinion, what is a reasonable trading commission fee % when adding to a portfolio?

I went back and did the math – I paid on average about 0.16% on commission fees this year. Of course I’m ignoring the cost to sell but that won’t be for a long time. Does that sound high? Personally it sounds alright to me in order to avoid the “cost” of just leaving my money in a “high” interest savings account, or as I call them “low” interest savings accounts.

Thoughts?

Canadian Couch Potato November 18, 2013 at 11:33 pm

@Kevin: Do you mean 0.16% of your portfolio’s total value? i.e. if the portfolio was $50,000 your total commissions for the year were $80? That seems a bit high to me (especially if the portfolio is large). Don’t forget there are also bid-ask spreads in each trade, which are often ignored but can often add up to more than the commissions.

You may want to add up the MER of your portfolio and the cost of the transactions. If the total is more than 0.45% or so, then the e-Series mutual funds may be a better choice than ETFs, since they carry zero commissions and zero bid-ask spreads.

Leave a Comment

{ 3 trackbacks }

Previous post:

Next post: