Q: “I currently have $30,000 invested in the TD e-Series funds. When the time comes to move to ETFs, what is the best way to do this while still making automatic contributions? Should I put my biweekly contributions into a money market fund and then make ETF purchases four times per year?” – C.D.
Too many investors think of the TD e-Series funds as little more than a stepping stone, and they can’t wait to “graduate” to ETFs. The appeal is understandable, since a portfolio of ETFs will typically carry a management fee of about 0.15%, compared with about 0.45% for the e-Series funds. But when I get this common question, I encourage the investor to think carefully before making the leap to ETFs, especially if their portfolio is small and they’re making automatic contributions.
For starters, management fees don’t tell the whole story. Index mutual funds are more investor-friendly than ETFs, and while the cost difference can be dramatic on large portfolios, the gap is narrower on smaller accounts. A fee difference of 0.30% shaves off just $30 annually per $10,000 invested, and that will be reduced—perhaps eliminated—by $9.95 trading commissions, bid-ask spreads, and the drag caused by uninvested cash.
More important, the benefits of an automated savings plan are likely to trump a modest reduction in management fees. Sure, you could keep contributing cash to the account and make a few manual trades every quarter or so, but I have seen this type of arrangement turn a disciplined investor into a market timer. When it comes to make those quarterly purchases, it’s easy for doubts to set in: “Should I really buy more Canadian equities now, when the economic news is so grim? Do I want to add more to this bond fund that seems to be falling in value?”
When you make automatic contributions and then rebalance only once or twice annually, you’ll make fewer tough decisions.
Testing the waters
Of course, if you can overcome these obstacles, there are indeed many advantages to using ETFs, especially as your portfolio gets larger and more complex. So if and when you decide to move away from the e-Series funds, here’s a strategy I’ve recommended for several DIY investors: start by switching to an ETF for your bond holding only, while continuing to use e-Series funds for your equities.
This makes sense for many reasons. First, your bond fund is probably your largest single holding, representing 40% or 50% of a balanced portfolio, so this one move will make a big impact. The e-Series version of the TD Canadian Bond Index Fund has an MER of 0.50%, which is expensive in this era of low expected returns on fixed income. Replacing it with the Vanguard Canadian Aggregate Bond (VAB) or the iShares High Quality Canadian Bond (XQB), which have fees of just 0.13%, would quickly reduce your portfolio’s cost from 0.44% to 0.29% (assuming a 40% target allocation for bonds).
Now that you have one ETF in your portfolio, you can get familiar with trading techniques. If you’ve only used mutual funds in the past, it takes a while to be comfortable reading ETF quotes, calculating the number of ETF shares to buy or sell, and placing limit orders properly. If you’re used to managing your portfolio on the weekend or after work, you’ll need to start trading during market hours and understand that your orders will be filled immediately rather than overnight.
Limiting all of this activity to just a single bond fund will reduce your stress and the likelihood of making a significant error.
The other benefit of this hybrid strategy is that it allows you to continue with your regular monthly contributions—though you will need to make an adjustment.
For example, let’s say you’re using a balanced portfolio of e-Series funds in your RRSP, with 40% in bonds and 20% each in Canadian, US and international equities. You’ve set up an automatic contribution of $500 a month and a systematic investment plan that puts $200 into the bond fund and $100 into each equity fund. If you switch to an ETF for your bonds, you can keep adding $500 to the RRSP and continue the systematic purchase of $100 of each equity fund. But the $200 that used to go to your bond fund would now just sit in cash.
You can add the cash to your bond ETF once or twice a year if necessary, and pay TD’s usual $9.95 commission. In any period where stocks happen to fall in value, however, you could also add the cash to your e-Series equity funds to rebalance your portfolio at no cost. This can reduce your costs and the amount of guesswork compared with an all-ETF setup.
During the transition, count the idle cash as part of your fixed income: if your target allocation is 40% bonds and you’re holding 36% bonds and 4% cash, that’s fine. Sure, there is some opportunity cost to sitting in cash rather than being invested in bonds, but it’s likely to be modest. With the expected return on a broad-based bond fund at barely 2%, you’re not missing out on much by having a couple of thousand dollars out of the bond market for six or 12 months.
See how this goes for a year or two: after that, go ahead and switch to an all-ETF portfolio if you’re comfortable. If you decide it’s not worth the extra work, just sell your ETF and go back to using the e-Series bond fund. You can try again in the future, but don’t feel compelled: you’re not settling for a second-rate solution. On the contrary, chances are you’ll execute your plan more consistently than many ETF investors, and you may even wind up with better returns as a result.