Should You Use Index Funds or ETFs?

[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
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.

158 Responses to Should You Use Index Funds or ETFs?

  1. Amy June 12, 2015 at 9:35 am #

    Few of your articles referred to multiple ETFs, and I don’t really understand the difference. In some of your recent articles, you mentioned about iShares Core S&P U.S. Total Market Index ETF (XUU). If I can only choose one ETF representing the US Market, should I choose iShares S&P 500 (XSP), XUU, or other? Thanks for your prompt response!

  2. Canadian Couch Potato June 12, 2015 at 10:33 am #

    @Amy: XUU tracks an index that includes the entire US market, while XSP and others that track the S&P 500 include only the largest companies. I tend to recommend total-market funds where possible for the added diversification.

  3. Amy June 13, 2015 at 7:44 am #

    For the international equity (excluding US), which in your opinion is better? In term of diversity and MER, etc. VDU, XEF, ZEA, or other? I learnt so much from you, thanks so, so much!!!

  4. Canadian Couch Potato June 14, 2015 at 9:50 am #

    @Amy: Any of those ETFs would be good choices. We tend to use XEF because of the additional exposure to mid- and small cap stocks, and because it holds the stocks directly, which reduces the impact of foreign withholding taxes.

  5. Joshua June 15, 2015 at 8:43 am #


    I’ve recently made the decision to do my own investing using the model portfolios here. Originally I was set up on a high MER mutual fund from a bank but I’ve grown comfortable doing things myself to the extent needed. I actually rather enjoy it. My plan is to take the existing mutual fund I have and move it to an assertive ETF mix (I’m young for now and am comfortable with the risk). My slight problem is that I continue to make monthly contributions (which I adjust yearly based on income – I’m a consultant and get paid in USD so it can be rather variable). Would using both index funds and ETFs be a viable solution here? Contribute monthly to an assertive index fund mix and rebalance at the start of the year by selling the index funds and buying ETFs. Ultimately even with just index funds I’d be rebalancing anyway, so it’s minimal extra work.


  6. Christina October 19, 2015 at 5:39 pm #

    Hi again:

    I have recently asked questions regarding Tangerine funds on another page.

    I thought I’d made up my mind on buying Tangerine fund but today I just learned that in order to buy/sell TD e-Series funds, I don’t need to open a TD Waterhouse/TD Direct Investing account. It’s all possible to do so by opening a TD mutual fund account. There’s only MER to pay & no commission or trading fees. It’s easier than I thought.

    However I remember reading about Dan mentioning in the model portfolio “Unfortunately, the e-Series funds are only available through an online account with TD Canada Trust or (preferably) a TD Direct Investing discount brokerage account.” (link: Why preferably a TD Direct Investing account? Is it because you can purchase ETFs, stocks, and more options?

    I think I have enough ($25K) to open up a TD Direct Investing account but I’m intimidated in doing the actual trading on my own and making costly mistakes. Besides the option of Tangerine fund, could I just dive in by opening up a TD mutual fund account (as there are no fees) to buy the TD e-Series funds as listed in the CCP model portfolio for RRSP purpose? Do I use the spreadsheet in the link for a yearly rebalancing? (link Does it ever happen that the amount (column E) you need to add/subtract is less than the minimum reinvestment? What would you do in that case? Also can I keep my money in the e-series portfolio until I retire as Iong as I rebalance on a regular basis?

    Thanks in advance.

  7. Canadian Couch Potato October 20, 2015 at 10:55 am #

    @Christina: When I wrote “an online account with TD Canada Trust,” I was referring to the TD Mutual Funds account you mention. Using an account like this does have some advantages for small portfolios, but it is very inflexible. With a TD Direct account you can eventually move to ETFs, GICs and so on, without having to open a new account.

    When investors have small portfolios and are intimated about trading in a brokerage account, I usually recommend Tangerine. The higher fee is worth it to avoid costly mistakes. For now, the most important thing is disciplined savings. Cutting cost to a minimum can come later.

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