Why Index Mutual Funds Still Have a Place

February 19, 2013

Responding to a recent article on mutual funds by Rob Carrick, a Globe and Mail reader rehashed a common refrain: “Perhaps mutual funds were once a great way for ‘average Canadians’ to invest, but they have been totally subverted by the greed and mediocrity of the financial institutions who dominate the field … Canadians are generally far better served by ETFs.”

The problem with remarks like this is they present the debate as “mutual funds versus ETFs,” and that’s the wrong way to think about it. The mutual fund industry in this country has enormous problems, to be sure: some of the highest fees in the world, deferred sales charges, and bad advice from salespeople with vested interests. These are all disgraceful practices, but they have little or nothing to with the mutual fund structure.

Index investors have broken free of the worst industry practices, but they still seem reluctant to embrace mutual funds. For example, when Scotia iTrade began offering Claymore (now iShares) ETFs without commissions, I heard from many folks who couldn’t wait to get on board. Many chose to ignore—even after it was pointed out to them—that most of the commission-free ETFs were far more expensive than the TD e-Series funds, and they were remarkably close to RBC’s family of index funds, which have always been available through iTrade and other brokerages. Investors who never considered the RBC Canadian Index were suddenly drawn to the iShares Canadian Fundamental (CRQ), even though both have an identical MER of 0.72%.

Where mutual funds have the edge

In many cases, ETFs are dramatically cheaper than comparable index mutual funds. But when the MER differences are less than 20 or 30 basis points—especially with small portfolios—mutual funds may actually have an edge, even if the ETFs are commission-free. Here’s why:

Preauthorized contribution plans. The key to investing success is disciplined savings—indeed, this matters far more than small cost differences. And for most people, the best way to enforce that discipline is to set up preauthorized mutual fund contributions. Yes, you can set also up automatic cash contributions to your brokerage account and buy ETFs manually, but many people simply don’t have the discipline to do this in a systematic, unemotional way. Those who don’t have access to commission-free ETFs may even let cash build up to minimize the number of trades they make. That will save a couple of $10 commissions, but the uninvested cash also causes a drag on returns.

Reinvestment of dividends and interest. ETF investors—not to mention those who buy individual stocks—seem to love dividend reinvestment plans (DRIPs) and speak about them as if they’re a magical form of compounding. But the fact is, mutual funds are far more efficient when it comes to reinvesting distributions: every cent stays in the fund because you can purchase partial units, so you benefit from compounding immediately, no matter how much you have invested.

Lower transaction costs. Experienced investors understand you can buy and sell index mutual funds without trading commissions, but that’s not the whole story. Remember too that mutual funds trade at their net asset value, which means they do not have bid-ask spreads. While most ETFs keep their spreads tight, not all of them do, and every buy or sell order comes at a cost, even if you’re using a brokerage that offers commission-free ETFs.

One reader recently asked me whether the appearance of commission-free ETFs made the TD e-Series “obsolete.” I’d answer with an emphatic no. ETFs are the best thing to happen to Canadian investors in decades, but they’re not always the right tool. For regular savers with modest portfolios—especially those who value simplicity and convenience—index mutual funds remain a better choice.

{ 70 comments… read them below or add one }

Ms Finance February 24, 2013 at 9:02 pm

If indexes track all the stocks on a market, such as S&P/TSX, why is the TD Can index beaten by the S&P/TSX by a lot?

Canadian Couch Potato February 24, 2013 at 10:13 pm

@Ms Finance: Not sure where you’re getting your data. The TD Canadian Index Fund typically trails its benchmark by less than 40 basis points, which is what one would expect from an index fund with an annual fee of 0.33%.

Jen February 25, 2013 at 2:50 am

Thanks for the response Dan. Just to continue from above…I’m the young investor with TD e-series who also has a TFSA account with Questrade. For now I will continue with the e-series.

However I have a bit of a “problem” now, I will soon have a side job as an independent contractor that pays in USD (not a lot but at least a few hundred per month) so now I’m wondering whether I should open an RRSP and use the USD to buy US-listed ETFs to avoid wasting money in currency conversion fees to contribute to the US/International e-series. I’ve read many articles about currency conversion/gambit but it’s mostly for CAD->USD or those who need to exchange a large sum of money. If so, should I reduce/stop the contribution of the US and International portion of my e-series?

One of the reasons that I think I should open an RRSP trading account is simply to avoid the 15% withholding tax. I will be deferring the tax deductions as my income tax bracket is too low (and I’m in QC). My goal is to max out my TFSA first then figure out what I should do next…RRSP or unregistered and claim dividend tax credit…the whole 15% withholding tax is nagging me. I guess RRSP seems more logical as it’s less paperwork and the growth is sheltered.

Also this is off-topic but I tried searching for threads on Canadian Money Forum but I couldn’t really find anything good on the best way to exchange/convert small amounts (i.e. few hundred to a thousand or two) USD to CAD regularly. Would you be able to give me some ideas?

Canadian Couch Potato February 25, 2013 at 9:18 am

@Jen: To be honest, I think you’re overly concerned about the withholding tax issues. Remember, it’s 15% of the dividends paid, and US equities currently yield about 2%. So you’re talking about an additional expense of just 0.3%, or $3 for every $1,000 you have invested in this asset class. It’s a trivial amount that should have no bearing on the TFSA v. RRSP decision. That decision should depend on your income tax situation.

Re: exchanging small amounts of USD, there really is no ideal solution. Norbert’s gambit will cost you two trading commissions, so it doesn’t usually work for small amounts. The best solution might simply be to open a USD savings account and keep your money there until you have a couple thousand to invest.

John February 25, 2013 at 10:44 am

@Jen I am in a similar situation where I have income in both US and Canadian currency, and I find that TD’s Borderless Plan the best deal for saving on exchange rates/fees. The plan gives you Preferred exchange rates every time you change Canadian dollars for U.S. dollars (or vice versa) on amounts up to US$25,000 (no minimum), and the $4.95 per month fee is waived if you keep US$3000 in the account or if you have a TD Select Service Account. It has a bunch of other benefits as well including a free US$ Visa Card if you travel to the US a lot on business like I do so you can pay your bills directly in US$ and again save the conversion charges. More details here: http://bit.ly/LuMBMo

Edwin February 28, 2013 at 1:54 pm

This is a great article Dan – the timing of this is excellent! I recently went with an e-series account, just a month before Questrade announced free ETF buys. I was thinking of making the switch. I think I will stick with the e-series funds for the time being, especially with the DRIP benefits and preauthorized contribution plans, until I have a larger amount to invest for ETFs. The breakdown and the benefits of index mutual funds is very helpful here.

ike March 8, 2013 at 4:34 pm

CCP, a hypothetical question. If everyone becomes an index investor, what would happen? would a stock market still exist? would indexes (indices?) exist?

Canadian Couch Potato March 9, 2013 at 11:34 am
Oldie March 9, 2013 at 2:19 pm

As CCP says, the question will always remain hypothetical. But, as such questions will still niggle away at my mind, from a Passive Investor’s viewpoint, I guess I will still worry about the answer in the context of how it will affect the performance of my (continued Passive approach) portfolio.

So I was gratified to find for myself that Larry Swedroe’s graphic thought experiment (in the cbsnews link in the list provided by CCP) involving an NBA contest for 100 free throws at $100 a pop favours the Passive Index strategy. The solution is certainly counter intuitive, but holds up well to examination. Even if your free throw percentage is above the league average, a rational analysis would show that the best strategy is to not throw and accept the resultant average prize money!! Amazing.

Rahim March 10, 2013 at 11:22 am

Hello CCP,

Greetings from Montreal. I’m a newbie index investor and find your blog every helpful!

I’ve started to make regular (automatic) biweekly contributions to my index mutual funds (currently with RBC simply because all my banking/credit/investment services are with them). My contributions are equally split: 34% Canadian Index, 33% US Index, 33% Canadian Govt Bond Index.

My question: is it a smarter strategy to make “manual” contributions and rebalance with every contribution (i.e., buying the laggard with every contribution; in line with my asset allocation)? Or should I keep with the automatic contributions and rebalance once year? Obviously the latter is “easier” to manage (less hassles/less thinking), but if it makes more sense to “actively” balance for each contribution, I may opt for this approach. Let me know your thoughts.

Thanks in advance!

Andrew F March 10, 2013 at 12:29 pm

Rahim, either will work fine. Do the one that’s easier.

Canadian Couch Potato March 10, 2013 at 1:25 pm

@Rahim: If your portfolio is small, monthly rebalancing is likely not worth the effort. Best to keep things simple and just rebalance one a year.

Oldie March 10, 2013 at 3:21 pm

@Rahim: Welcome, from a fellow newbie! You will find this community very helpful and generally very knowledgable, with varying individual biases and differences of opinion, but generally aligned with the Author’s stated principle of Passive Index Investment, and all interested in learning from each other.

You seem to be in great shape, with a defined plan in place and in action with automatic contributions, and asset allocation 2/3 equity, 1/3 bonds, (presumably all in RRSP). This set-up would be hard to beat. However, as a fellow newbie, I am curious why outside of your Canadian equity, you have only US equity, which, admittedly, makes up a huge chunk of the world stock market. Is there a reason for avoiding the other half of the world stock market in your plan?

Rahim March 10, 2013 at 3:46 pm

@Oldie: Thanks for the encouragement! This is all very exciting for me and I feel that I’m finally getting my finances in order.

You bring up a very good question. I’m currently focused on paying off some remaining student loans so I have limited funds to contribute to my RRSP (1/3 govt bond; 2/3 Cdn & US equity). Therefore I decided to focus on Cdn and US equity for the time being (this is what I believe the CCP refers to as the “Classic Couch Potato Portfolio”).

Perhaps you can help me with next steps. I’d like to also open a TFSA account with index funds. I have 2 options: 1) stick with RBC (and keep all my accounts with them), or 2) open a TFSA with the TD e-Series line of products (but keeping all my other accounts with RBC).

Any suggestions on how to construct the associated TFSA account? Should I create a TFSA that:
1) Simply replicates the investments my RRSP account, or
2) Focuses on what isn’t already covered in my RRSP (e.g., international equity). For example, 33% bond index; 67% international equity index. (I’m presuming that having a bond component in the TFSA is essential). This way, my overall portfolio (RRSP + TFSA) will include worldwide equity coverage.

(Note: I’m planning on contributing a 4:1 ratio in RRSP:TFSA).

This is a daunting task for a new, so I welcome your thoughts/suggestions!

Oldie March 10, 2013 at 7:13 pm

@Rahim: First off, no criticism was intended, I was merely asking about your strategy, and anyway, from my basic very knowledge of investing, missing the half of the world of stock market is not a big deal, merely perhaps missing a small opportunity for further diversification at no greater long term risk, and, hopefully, minimal, if any extra bother. (All of the listed model portfolios contain some variation of Canadian/US/Rest of World.)

I think the decision to put funds into TFSA vs RRSP if you only can do one or the other has been covered elsewhere, but boils down to whether you expect your marginal tax rate to be higher at withdrawal (retirement) than during the contribution period. Either way, do it, as the difference is small, and better than not saving at all or investing outside a tax-free account when you still have contribution room for any tax-free plan. This dispensed wisdom skirts dangerously close to the limit of my pay-grade :)

Perhaps some wiser and more experienced persons can address the rest of your issues better than I can. But rest assured you’re basically well set up, and the rest is fine tuning; make sure you don’t spend so much effort fine tuning that you neglect the sound foundation you have established.

Rahim March 10, 2013 at 9:32 pm

@Oldie: many thanks for your insight!

As soon as my student loans are paid off, I’ll be able to contribute to both my RRSP and TFSA. If anyone has any recommendations as to whether I should simply duplicate my RRSP index funds when constructing my TFSA account, or use another strategy (i.e., diversify by selecting other index funds for my TFSA), I’m all ears :)

Thanks again!

Mike May 20, 2013 at 8:38 pm

Dan,

A quick question for you. You often say that index funds are better for accounts under $50,000, and I am not sure why. I am weighing between RBC index funds for my daughter’s RESP or instead going the ETF route with the same allocations. Over the course of the next 18 years, wouldn’t the difference in MERs make a signifcant difference ? Please explain, and thank you in advance.

Canadian Couch Potato May 20, 2013 at 8:55 pm

@Mike: You can’t look only at the MERs. You also have to consider that buying and selling ETFs involves commissions, and at the big-bank brokerages these can be as much as $29 if your account is under $50,000. Even if you pay only $10 per trade, ETFs are inappropriate for investors who are contributing small amounts monthly. I go into more detail here:
http://canadiancouchpotato.com/2012/07/30/comparing-the-costs-of-index-funds-and-etfs/

Mike May 22, 2013 at 9:23 pm

Dan,

Thank you for your help. Lucky for me you already had an awesome post written on this subject! I would like to ask your opinion on one more of my financial dilemmas and forgive me for all the questions as I am a newbie to the investment world. I currently have a LIRA in the amount of $65K from a former employer (currently sitting in a GIC until I figure out what to do with it). As you know, the rules state that you cannot add to the LIRA, but must keep in locked in until you can start withdrawing it upon retirement. My first instinct was to throw it into a decent low-c0st balanced fund and let it sit (I have over two decades until retirement). Now that I am learning more about ETF’s and am intrigued by their possibilities I wonder if you could suggest a mix / strategy that would suit this particular problem. Keep in mind that since I cannot add to the LIRA account, I cannot take advantage of dollar-cost averaging and buy more of a certain ETF in down markets. Any thoughts?

Thanks

Canadian Couch Potato May 22, 2013 at 11:39 pm

@Mike: It all depends on what you hold in your other accounts. That $65K should be considered part of your overall retirement portfolio, along with your RRSP. Once you sort that out, an ETF or two may be appropriate: it would help to set up a DRIP sop your dividends will be distributed as new shares, since small amounts of cash will be hard to reinvest in a LIRA.

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