[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|
|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|
|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.
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: https://canadiancouchpotato.com/model-portfolios-2/) 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 https://canadiancouchpotato.com/wp-content/uploads/2011/03/Rebalancing-spreadsheet.xls) 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.
@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.
Question: If you have a TFSA with a modest amount (15K) and a regular indexed investment account, with the same brokerage (questrade): would you still recommend indexed mutual funds? Buying ETFs is free with QT.
@Luke: If you sure already set up at Questrade then, sure, ETFs will be a better option, especially since you won’t have access to the e-Series funds.
I recently decided to start investing for myself. I have a large cash position that I attained from an inheritance. I’m thinking of buying ETFs because of the large cash position. The question I have is it seems crazy that I put an order in for a large number of shares of an ETF. Is it reasonable to put an order in for 5000 shares of XEC or should I buy in smaller orders?
@Frank: There is no reason to buy ETFs with multiple orders: 5,000 shares is a lot for an individual, but it’s not much for the market maker filling your order. I have two suggestions, however: try to get access to “Level 2” quotes, which show you how many shares are available at each price. This will let you know whether 5,000 shares are available at the quoted ask price or whether part of the order will be filled at a higher price:
Second, make sure you use a limit order. You should always do this, but it’s particularly important with larger orders to avoid surprises:
My daughter just had her first child and would like to start a RESP. I suggest she setup an iTrade account and begin investing into one of their commission-free ETF’s. Initially one of the Canadian broad based market finds (e.g., HXT @ 0.07% MER) and once the account has built up sufficient finds she could diversify in to the US market (e.g., HXS @ 0.10% MER) and eventually balance things out with one of the bond etf’s, all commission-free.
There will be an account admin. fee of $25 per year but with no trading fee’s and extremely low MER’s I think this would be a good trade off. BTW, she also uses BNS for her regular accounts so everything can be managed through a single login.
Does this make sense or would there be better options.
@Dave: It’s hard to go too far wrong if she is contributing regularly to the RESP and collecting the full government grant. But in general I don’t like the idea of starting out with a single asset class and then adding other as the account gets larger. It’s better to start with a diversified portfolio and keep it diversified all the way.
A couple of questions regarding index funds vs etf funds and cost associated with both.
1. How would dollar cost averaging into index mutual funds on a monthly basis vs a yearly lump sum into the eft fund impact performance? Meaning the fees would be cheaper for the eft, but if you are investing on a monthly basis your money will be in the market longer and will average out the share price. A yearly lump sum you could be paying overall a higher price and you lose time in the market as well. Should this not be factored in as well?
2. How the does spread for etfs contribute to the cost of owning the eft? All discussions focus mainly on the MER and commissions, but I am not clear on how the spread would impact (if at all) the overall cost of trading etfs vs no load index mutual fund.s
Currently I am considering moving my bond index funds with cibc to Vanguard VAB and VSB to save fees. The Cibc premium bond indexes have a MER 0.42% where Vanguard are around 0.09%. Seems to be me a like a good move as I don’t trade much on the bond indexes and my bond holdings are several hundred thousand.
@Cameron: Thanks for the comment and the questions.
1. Dollar-cost averaging is a widely misunderstood strategy, in my opinion. Bottom line, invest the cash as soon as you have it. If you are making contributions with every paycheque, there is no real decision to be made — unless you’re talking about saving a year’s worth of contributions and making one large lamp sum contribution at the end of the year, which is unlikely to ever make sense: https://canadiancouchpotato.com/2018/01/22/ask-the-spud-should-i-use-dollar-cost-averaging/
That said, if you’re making small regular contributions (say, $500) and you would pay a commission each time you buy an ETF, then that clearly is a bad trade-off. This is one situation where index mutual funds have the edge over ETFs.
2. Bid-ask spreads can certainly have an effect if you’re buying and selling ETFs frequently: again: this another advantage that mutual funds have over ETFs. But if you’re just adding to your holdings from time to time the effect should be small, and the significantly lower MER will easily outweigh that cost, especially on a six-figure holding.
I don’t see a reply to Joshua’s comment dated June 15, 2015 and I’d really like your advice on this because my circumstances are similar. I have several hundred thousand dollars to invest as a lump sum (or gradually) but I want to make automatic monthly contributions of $500 – $1,000 as well. Would you recommend using both ETFs AND index funds, which would likely require maintaining two separate accounts in accordance with your model portfolios, or would you recommend absorbing the extra fees and just sticking with index funds? Thank you!
@Bryan: I would never recommend using different accounts so you can combine index funds and ETFs. It’s much too complicated and not worth it to save a few trading commissions or a few basis pints in MER. Better to come up with a simple solution, even if it’s not the absolute cheapest. Here’s my suggestion: