Your Complete Guide to Index Investing with Dan Bortolotti

Couch Potato Basics, Part 1: Low Costs

2012-10-11T14:11:46+00:00January 10th, 2010|Categories: Indexing Basics|10 Comments

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