Should You Use Index Funds or ETFs?

June 25, 2010

[Note: A more up-to-date discussion of this idea, including a spreadsheet to help you with the math, can be found here.]

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% 0.27% 0.2 × 0.27 = 0.05%
iShares S&P 500 (XSP) 20% 0.26% 0.2 × 0.26 = 0.05%
iShares MSCI EAFE (XIN) 20% 0.55% 0.2 × 0.55 + 0.11%
iShares DEX Universe Bond (XBB) 40% 0.33% 0.4 × 0.33 = 0.13%
Total MER for portfolio 0.35%

If you’re investing in only these four asset classes, the MERs are not dramatically different. The iShares version has an edge of just 10 basis points.

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 × 0.35% with iShares ETFs = $87.50

Turns out the difference in MERs works out to only $35 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 $200 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 0.35% $87.50 4 $115.80 $203.30
iShares ETFs @ $9.95 0.35% $87.50 4 $39.80 $127.30

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 $120,000 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 $40,000 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.

{ 137 comments… read them below or add one }

Paul August 7, 2012 at 10:07 am

Hi,

I currently have a large index fund portfolio based on the couch potato strategy. I’ve been growing this portfolio for a long time and have finally decided to stop monthly contributions. Currently the portfolio is greater then 150k. so I was considering switching it from index to EFT to save on the MER.

Please correct me if I’m wrong, but if I switch, this involves:

Selling all current index stocks, thus incurring paying taxes on the money that I’ve made on the index investments.

If I have to pay a lot in taxes for what I would kind of consider an early redemption, it seems like it’s a bad idea to switch…

What are your thoughts?

Canadian Couch Potato August 7, 2012 at 12:38 pm

@Paul: If you’re investing in a non-registered account, then yes, you will have to pay tax on any capital gains you incur if you sell your index funds and switch to ETFs. Of course, if any of your funds are down (international stocks?) you can offset some of the gains with losses.

It’s impossible to offer any specific advice, but in general, any time you liquidate a big position and face a large tax bill, it makes sense to do it carefully and strategically. Maybe wait for a year when you have lower than normal income, for example. Or until you’re able to offset some of the gains with other capital losses you might incur.

Hanah August 9, 2012 at 9:27 pm

I was told by td waterhouse that there is $100 annual fee that is imposed unless there’s at least $25,000 in the account (RSP). I assume this fee makes an impact on the above analysis?
regards,
Hanah

Canadian Couch Potato August 9, 2012 at 9:39 pm

@Hanah: Yes, you definitely have to factor that in. There is a place for annual fees on the spreadsheet.

CJ August 9, 2012 at 10:19 pm

Hanah et al,
TD Canada Trust (not Waterhouse) offers a “Basic SDRSP” (self-directed RSP) that can house e-Series mutual funds.

The annual fee for that is only $25, below the $25,000 threshold.
Source: http://www.tdwaterhouse.ca/products-services/investing/discount-brokerage/types-of-accounts/assd.jsp

Index Investor August 15, 2012 at 8:18 pm

Hi CCP,

I just set up my brokerage account and have reproduced the “Complete Couch Potato”. Thanks for all the help in this thread!

I was wondering which money market fund you would recommend parking my leftover cash in?

Canadian Couch Potato August 16, 2012 at 12:39 pm

@Index: Money market funds no longer make sense for anyone, in my opinion. You will get far better yield and total safety with a high-interest savings account. There are a number of little-known mutual-fund-like products that serve this purpose. Here’s a piece I did about them a while back:
http://canadiancouchpotato.com/2010/10/12/parking-cash-in-your-portfolio/

The rates are out of date now, but the products are all still around. Call your brokerage and ask which one they prefer. At iTrade, for example, they use the Dundee fund and they allow same-day liquidity with as little as $100 per transaction.

Index Investor August 25, 2012 at 4:37 pm

Hi CCP,

I just wanted to start by thanking you for all your help. This website and your books have allowed me to take control of my investment portfolio!

My question for you today is in regards to my mother’s portfolio. I recently set up a TD brokerage account for her in anticipation of implementing the Global Coach Potato with E-series funds. As your book mentioned the most important part of an investment strategy is figuring out an initial asset allocation. However, my mother and I are having a difficult time coming up with an appropriate allocation for her portfolio.

My mother is in her early 60s and is already retired. She is in the fortunate position of not actually requiring her RRSP/TFSA funds to supplement her retirement income due to various pensions. She is also able to stomach a lot of risk as she went through the 2008 financial crisis without any emotional difficulties. The size of her portfolio is approximately $150,000 and she has stated that her main goal is to leave a sizable nest-egg for her children.

I was thinking a balanced 60% stock/ 40% bond portfolio would be appropriate for her. At the same time I was debating being more conservative with a 60% bond/30% equity/10% REIT portfolio which is more in line with the “100 minus your age in bonds” rule of thumb. This is also the portfolio that you mentioned under “Putting it All Together” on page 61 of your newly published book! However, my mother’s situation and “Cheryl’s” situation are quite different.

I was just wondering what you would recommend in this situation?

Thanks again.

Canadian Couch Potato August 25, 2012 at 8:55 pm

@Index Investor: Thanks for the comment. It’s really impossible for me to suggest an asset allocation for someone: it’s really a decision you have to make yourself. But if you really are torn, why not start off with a 50-50 portfolio and then revisit the idea in a year or two?

http://canadiancouchpotato.com/2011/12/15/the-timeless-harmony-of-a-balanced-portfolio/
http://canadiancouchpotato.com/2010/11/01/the-50-percent-solution/

AS September 17, 2012 at 2:06 pm

Thank you, CCP. I have been gobbling up your words of wisdom. I’m just about to start my indexing journey and I want to do this right.

I like the idea of dollar cost averaging and the forced savings that comes with the e-series. However, there seems to be a greater opportunity to diversify into the sexy stuff with ETFs (Reits, real return bonds, and eventually, small caps, etc.). What do you think of the following to combine the benefits of both:

Currently, I want to invest a lump sum of about $65,000 into a diversified ETF portfolio with TDWaterhouse. At the same time, I’d like to make bi-weekly or weekly contributions to the e-series.

Then, once there’s a $10,000 to $12,000 lump sum in the e-series account, I would like to sell and transfer all of the e-series funds into the ETF portfolio.

Do you see any glaring problems/errors with this strategy? Do you think this is an appropriate way to combine the benefits of Index Funds and ETFs? Any assistance would be greatly appreciated.

Canadian Couch Potato September 17, 2012 at 2:12 pm

@AS: I think that’s a good compromise, although a better idea might just be to use the e-Series funds wherever possible and add a few ETFs for the asset classes that are not covered by e-Series funds. That is, combine the Global Couch Potato Option 2 with XRB, ZRE and maybe VWO for emerging markets. Make regular contributions to the e-Series only and just rebalance once a year as necessary. That would be easier to manage.

Michael December 22, 2012 at 12:52 am

I am interested in commencing the Canadian Couch Potato strategy and already have an account with the Questrade discount brokerage. This article is predicated on commission-free trading of index mutual funds, however Questrade will charge me a commission on such trades.

Which brokerages will allow me to freely trade index mutual funds without trade commission? This is critically important, as I am starting my investment journey with a small amount of 3k.

I also have an account with ING Direct. Perhaps I should pursue mutual fund investing through them?

Canadian Couch Potato December 23, 2012 at 12:00 pm

@Michael: As far as I know, Questrade is the only discount brokerage that charges commissions to buy no-load mutual funds. With $3K to invest, it really doesn;t make sense to use ETFs or to worry too much about small differences in MER. A simple portfolio of index mutual funds (whether it’s the TD e-Series or the ING Streetwise portfolios) are often the best choice for beginning investors.
http://canadiancouchpotato.com/2012/03/05/some-advice-for-new-potatoes/
http://www.moneysense.ca/2010/05/27/become-a-couch-potato-investor-with-less-than-5000/

jack January 12, 2013 at 11:53 am

Poor advice, as long as she’s not trading but a buy and hold investor then trading fees are miniscule, trading costs as low as $4.95 are available, no need to go with a one of the big banks and pay out of the nose ($30). She can buy 4 funds across sectors and indexes and call it a day, once she has $1000 saved then she can buy into one of her funds, preferably the one that is the best value at the time.

She will need to do some reading and start to get an understanding before she gets in, but its not rocket science by any measure.

Michael January 12, 2013 at 3:58 pm

@Canadian Couch Potato

Thank-you for your reply. With Questrade, I have a “Tax-Free Trading Account”. I don’t see an option to open a tax-free mutual fund account in TD or ING? Am I overlooking something?

I am definitely not using up all of my potential TFSA contribution amount in my Questrade account.

Michael

Canadian Couch Potato January 12, 2013 at 5:37 pm

@Michael: I’d suggest you call the customer service desk (whether at Questrade, TD or ING) and tell them what you want. They will make sure you open the right type of account.

dennis March 25, 2013 at 2:18 pm

Good-Day ; I recently opened a TFSA waterhouse account with $10,000. I am new to this as well and cant decide whether to use index funds or e-funds. I guess I am trying to keep the MER low and not be too consevative. Any advice ?

Canadian Couch Potato March 25, 2013 at 2:22 pm

@Dennis: Just to clarify, e-Series funds are index funds. With a $10K account, the e-Series funds are almost surely preferable to using ETFs.

NJ April 4, 2013 at 3:27 pm

Hello @CCP

First off, the April fool joke was great! A quick second I was sad to read, however, thinking more, I thought, no, you just cannot give up like that!! :)

My question for you-
My company just got bought by another and so our current group RRSP contribution (with Industrial Alliance) has to be moved. We have been given an option to either move to the new group RRSP with Great-West life or any other institutions. I have approx. 23K. I was thinking to open TD Warehouse account and go for index funds. I currently have TD e-series account (less thank 10k) with TD Canada Trust.

- Is this a good thing to do? Or what are other options?
- Should I do Dollar Cost Averaging?

Any other advise is appreciated.

Thank you
NJ

Canadian Couch Potato April 4, 2013 at 3:52 pm

@NJ: If your company matches part of your contribution, you may have to keep it in the group plan to qualify. But if that’s not a concern, it’s generally best to keep your RRSP holdings in a single account. Can you combine the group RRSP and the account you already have open at TD?

NJ April 4, 2013 at 4:37 pm

@CCP: I confirmed with my company that I can transfer funds to “Any” institution even though it has employer’s contribution in it. I will also double check with TD if I can transfer group RRSP amount to the regular RRSP account (but my HR is confident, we can do this).
So, if I can, then what? Should I just move to TD e-series RRSP account or TD Waterhouse and also should I do DCA?

Canadian Couch Potato April 4, 2013 at 4:49 pm

@NJ: A TD Direct Investing account (the new name for TD Waterhouse) would give you an opportunity to use both the e-Series funds and ETFs. I can’t tell you how to invest, but if you set up contributions with every paycheque that is an effective strategy that benefits from automatic savings and DCA.

NJ April 4, 2013 at 4:55 pm

@CCP thank you! I wont be contributing from every paycheck. I have to move the existing 23K out and invest at another institution, so I was wondering if I should be investing this 23k over a period of time or right away.

AS July 2, 2013 at 6:48 pm

Hello CCP:

I met with a financial advisor today. He offered a free check-up. I was weary (and perhaps I should continue to be) but this is what he informed me.

He told me that aside from the MER, ETFs also charge an additional fee for all of the transactions they do over the course of the year. This additional fee can be as much as 1% on top of the “MER quote”. For example, a 0.4% “MER quote” (advertised) + another 1% transaction/management charge (not advertised) = 1.4% total fees for holding the ETF. He tells me that since this is the case, it would be about the same to hold a low-cost mutual fund.

Now I thought an ETF MER encompasses all of the fees I would be charged for holding an ETF. The advisor says this is not true because current ETF regulations do not require advertisement of these additional expenses.

To be honest, this sounds like hooey to me, but I can’t confirm if it is. Could you please clarify?

Jakub November 4, 2013 at 1:10 pm

Hi CCP,

Sound advice as always. However low cost brokerages together with the option to now buy ETF for free, change the numbers.

Using your numbers of 0.60 MER for MF and 0.30 MER for ETFs.

Two trades/sales per year (rebalancing?) @ 4.95.
MF (3400 * 0.006) = 20.4
ETF (3400 * 0.003) +(4.95*2) = 20.1

Since at least questrade now no longer charges for ETF purchases. You can certainly do small regular monthly contributions. The tipping point in favour of ETF is at around 3,400 dollars. As shown above. I’d guess most people will hold more than that in their kids RESP. I’d also simply suggest not making sales as part of rebalancing in portfolios below 4,000. Hence no commission.

Having said that your point about dividends being immediately reinvested in MF and, opening brokerage accounts not being for faint of heart still holds true.

I’ll certainly re-run my numbers should my brokerage starts charging me for ETF purchases, right now it’s ETF all the way.

Navy_111 December 4, 2013 at 1:56 am

Hi CCP,

Just wanted to tell you that your site is really a gift to all of us interested in building a small nest egg.

I am Canadian expat living in Dubai unfortunately Vanguard low cost index funds are unavailable here but I found an alternative with ETF’s.

By opening a brokerage account with Citi bank Dubai I have access to the US stock market including ETF’s.

I was thinking of the following portfolio:
40% VTI
30% VXUS
30% BND or AGG (bond’s mid term)
Rebalancing once or twice a year to keep the same ratio

I have a lump sum of 150k usd to invest
Would it be better to invest the whole amount or do a monthly contribution of around 10,000 usd per month for 15 month.

Charges:
Citi bank commission: 0.3% buy or sell
ETF commission: 0.065% buy or sell
Custody Fee: 0.2% yearly (quarterly charged) on total amount

Cheers,

Canadian Couch Potato December 4, 2013 at 3:43 pm

@Navy_111: Thanks for the kind words and sorry for the delay in replying.

The short answer is that the evidence clearly shows dollar coat averaging usually results in lower returns compared with investing a lump sum. However, if you feel strongly that it would make you less anxious, then it’s not an unreasonable strategy. I’ve written about this idea here:
http://canadiancouchpotato.com/2013/05/31/does-dollar-cost-averaging-work/

Good luck!

Tony December 5, 2013 at 12:14 pm

Does it make sense or worth it to buy all e-series US equity funds, i.e. US Index, Dow & Nasdaq?
Thanks

Tony December 5, 2013 at 12:15 pm

Isn’t there much overlapping?

Canadian Couch Potato December 5, 2013 at 9:18 pm

@Tony: There would be almost 100% overlap. The S%P 500 covers all of the stocks in the Dow and almost all of those in the NASDAQ.

Sean January 9, 2014 at 5:33 pm

Hi CCP,

For a student debating on investing $5500, are mutual funds/etfs worth it? Since the MER will be so minimal, does it really make much of a difference? I was debating between ING streetwise and the TD-eseries, and I’m no longer sure which one to do!

By the way, thank you for your hard work. Everything is so informative here.

Canadian Couch Potato January 9, 2014 at 7:18 pm

@Sean: Thanks for the comment. The Streetwise Portfolios are idea for relatively small accounts: the account is much easier to open and you never have to worry about rebalancing because it’s done for you. Have a look at our white paper, which gives step-by-step instructions for setting up an account:
http://canadiancouchpotato.com/2013/09/12/the-one-fund-solution/

Sean January 9, 2014 at 8:31 pm

I must say, CCP is very punctual and informative with the replies. Thanks for the information, I’ll definitely give it a read.

Keep up the great work.

Ryan January 24, 2014 at 12:50 pm

I just recently came across your site as I was trying to understand the difference between ETFs and Index Funds.
Just wanted to say that this is the FIRST time that I’ve seen someone go into this much detail using actual examples, numbers and calculations to explain something like this. I also saw and downloaded the spreadsheet you created that clearly shows the difference in overall cost between ETF and Index Funds.

Usually, I read/hear people(personal finance people) say general comments like “stay away from MERs because they eat away at your returns” We’ve all heard it. But the devil is in the details, and it’s ALL about the numbers. You HAVE to run the numbers to see what the OVERALL impact will be on your portfolio on a yearly basis.

I’m a numbers guy, and I love using spreadsheets to show the differences between options because it clearly shows you what the outcomes will be based on numbers you plug in.

So thank you very much CCP for providing these details which help to give clarity to a decision that can be very complicated.

Canadian Couch Potato January 24, 2014 at 1:16 pm

@Ryan: Many thanks for the comment, and glad you found this useful. You’re right, for many people the discussion never gets beyond “mutual funds are bad, ETFs are good,” and the assumption is that MERs are the only factor to consider, instead of one of many. You may also want to check out this newer post:
http://canadiancouchpotato.com/2012/07/30/comparing-the-costs-of-index-funds-and-etfs/

Thanks also for pointing out the broken link, which is now fixed.

Seth March 19, 2014 at 6:57 pm

Fantastic information – thank you for your efforts. I have small RRSP and RESP portfolios of TD index mutual funds (less than 5k). Based on the information here, that seems to be the smart approach. My question though, is when does it make sense to convert over to a Waterhouse brokerage ETF portfolio if the transfer fees to do so are so high?

Canadian Couch Potato March 19, 2014 at 7:39 pm

@Seth: Many brokerages will reimburse you for the transfer fees charged by other financial institutions. There is always a minimum amount of about $15 to $25K, so I’d suggest calling TD and finding out if this is possible. But the e-Series funds are a great choice and I would not be in a hurry to switch to ETFs.

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