[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 |
0.45% | ||
| 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.
Although several people have explained to me that it doesn’t make a difference, I still wonder if there might be long-term risk advantages for people who invest monthly as opposed to buying a whole bunch of shares just once a year. Over 12 years, you would be buying shares only 12 times with a once-a-year ETF strategy whereas if you bought shares every month you’d have 144 transactions.
I get the feeling that with just 12 annual transactions, the odds that you could be hitting the market at the wrong time every time would be greater than if you had 144 transactions spread evenly over every year for 12 years. Of course the odds that you’d be hitting the market at the RIGHT time would be greater too, but it seems like more frequent investments would reduce your risk. Does this make sense?
Brad: What you’re describing is the whole idea behind dollar-cost averaging. There’s no easy answer to which strategy works best. If you make one lump-sum deposit in January, it does have the benefit of compounding for longer than if you spread it out over the next 12 months. I think most people invest monthly primarily because it’s easier on their cash flow, though it’s true that you may end up with fewer regrets.
I found this article interesting:
http://www.moneychimp.com/features/dollar_cost.htm
[…] investment @ MillionDollarJourney -Why asset allocation is so important @ GreenPandaTreeHouse -Should you use index funds or ETF’s? @ […]
Great post. I would agree with you, certainly given your number-crunching evidence, creating an ETF portfolio is not very cost effective for any portfolio value under $35 K. If however, you manage to have household assets over $100 K, I know TD Waterhouse can group those accounts for you so your trading fees can be $9.95 instead of $29-ish.
Regardless of what you pay in transaction fees, I think the most important factor (which you have correctly hit on) is if you’re an ETF investor, you’re a DIY investor. Holding any discount brokerage account, you would certainly need to be comfortable with your own transactions. That can be intimidating for many inexperienced investors.
Another thing that isn’t mentioned is the tracking error and how that plays in mutual funds vs. ETFs. For instance, in your analysis, a sample situation shows the difference to be less than $7; however, the tracking error of the US/Int’l e-Fund offered by TD is much larger than the corresponding Vanguard ETF.
It’s definetely something to consider when the tracking error of a mutual fund is off by 3-5% vs. the 0.2-0.8% tracking error of an ETF.
[…] advocate Ken Kivenko, there’s an interesting article at Canadian Couch Potato entitled Should you use index funds or ETFs? Click on the link for the full article, which I won’t attempt to reprise in depth […]
“[with ETFs] your dividends sit in cash until your annual rebalancing date.”
That depends on the ETF and broker – at TD Waterhouse, I’m able to have many of my ETF’s dividends DRIPped.
On the other hand, typically with ETFs, even if you DRIP your dividends, you have to buy full shares, and as you reported today (https://canadiancouchpotato.com/2010/06/28/more-etfs-now-paying-monthly/), recent changes in how frequently ETFs pay their dividends may make this option a little less attractive to investors with smaller portfolios.
@Simms: I would agree in principle, and in fact, if any index fund had a tracking error of 3% I would run screaming from it. Vanguard is unquestionably the best at keeping tracking errors low, but the US and international TD e-Series Funds have performed well over the last five years: their tracking errors, on average, are well under 1% annually:
http://www.canadiancapitalist.com/tracking-error-in-td-e-series-funds-part-2/
While it’s true TD’s e-series is a better deal for smaller portfolios than iShares ETFs, you forget one vital piece of information. This woman is an investing neophyte. You’re simply transferring the advice from her advisor to a TD employee. That does little good in the long-run unless she is able to educate herself. If not, you’re just giving more money to the banks.
@Will: Sarah can open up her own e-Series account online and manage her own portfolio with no trailer fee. I’m not sure who the “TD employee” is that you’re referring to.
Four well selected managed funds will out perform the above funds …because E_funds or index Funds can’t beat the market….but carry on
@DJ: You’re absolutely right: well-selected active funds would outperform the e-Series funds. There’s only one problem: they only appear “well selected” after the fact. The chances of choosing actively managed funds that will outperform index funds over a five-year period are perhaps one in 15 if you go by the SPIVA data. Over an investment lifetime the probability is extremely small.
[…] Should you use Index Funds or ETF’s asks the Canadian Couch Potato, which is a good query, I guess the one you understand best is the best answer. […]
You know, the ING Streetwise funds look pretty attractive for new accumulators. As far as I know there is no annual fee for the account, and no fee to open either. If you are putting aside say 2500 to 5000 a year, your fee really only amounts to 25 to 50 bucks alone. I believe a TD self-directed rrsp has an annual fee of 25 bucks a year.
So, in the end you break even. Also, the funds are balanced – no need to rebalance yourself. You can truly set it and forget it.
Great blog, I’ve followed your moneysense articles over the last year or so and this blog really puts your work over the top. I’m very happy to have found it.
@investnoob: Many thanks for your kind words. I’m glad you’re enjoying the blog. I agree with you about ING’s Streetwise Funds and have recommended them on the blog and in my MoneySense column. You can certainly build your own index portfolio with a smaller MER, but for small amounts of money ING is very friendly: no commissions or account fees of any kind.
I’m looking to start couch potato investing. I’m going to be starting with a smaller amount of money. I have 2 questions:
1. What are the pros/cons between using TD’s index mutual funds vs using ING streetwise funds?
2. With interest rates on the rise, is it still a good time to buy the bonds index fund?
Thanks for all the information
@Matt: The benefits of the TD e-Series funds are lower fees and the ability to customize your asset allocation. The cons are that the account is a little more difficult to set up and manage. ING Streetwise Funds can be set up online in a few minutes, plus you never have to rebalance them, because that’s done for you.
As for bonds, that’s a common concern now, but remember that interest rates cannot be “on the rise”: the only thing you can say with any certainty is that “interest rates have gone up in the recent past and may go up in the future.” No one one knows when or how much interest rates will move. Remember that people have been worried about this for more than a year, and in the meantime, bonds have returned about 6% over the past 12 months. Long-term bonds, which many people thought would be devastated, are up about 14% in the last 14 months.
Always remember that no one can predict the future returns of any asset class, and if you plan to use the Couch Potato strategy, it only works if you stick to your asset allocation through all market conditions.
I think managing E-Series accounts feels much easier than ETFs due to the free transaction costs.
Also, some hardcore *indexing* proponents swear on Mutual Funds vs. ETFs due to the daily vs. instant balancing that goes on.
Now Schwab, Fidelity and Vanguard have commission free in house ETF’s. Making rebalancing not a problem. Your Yearly account fee is all you have to pay. The low initial investment makes it easier for new investors to get started. Most decent mutual funds have a minimum of $1000-$3000.
@50Plus: Unfortunately, Canadian investors do not have access to commission-free ETFs:
https://canadiancouchpotato.com/2010/02/03/will-we-soon-trade-etfs-for-free/
What about the tax implications of using index funds vs etf in a non-registered account ? From what i understand, ETF generate taxable event only when they are sold while index funds result in a yearly T1 slip.
Anyone can provide information regarding this ?
@Dong: Both ETFs and index funds may generate capital gains, but the ETF structure is less likely to create taxable events. This article may help:
http://www.disnat.com/en/knowledge/etf/etf3.asp
What a great blog! Plus the comments and Dan’s responses provide even more value for the time invested reading everything. It’s the first blog I find worth reading wall to wall…
Regarding the break even point to move from funds to ETF, here’s a suggestion:
Once you reach that break even point and are buying into ETFs, why not keep the index mutual funds open with just the minimum amount required, often only $100. Why? To catch your monthly contributions or any other cash accumulating in your account, such as the imperfect drip of ETFs and for rebalancing. A DRIP is a dividend re-investment plan.
The idea is to minimize trading fees by moving the money from an index mutual fund to an ETF only when the amount is high enough to justify the cost, keeping the commission at 1% of the trade or less. ETFs are wonderful, but they have their issues: US$ ETF, such as Vanguard’s super low MER ones, do not drip in a Canadian account, at least not in a TD Waterhouse account. You could uswe the dividend payments every time they reach the minimum for a deposit in an e-series TD mutual index fund, which is $100.
Canadian ETF do offer the drip option, reinvesting the dividend payments in the form of a purchase of new shares. However they don’t drip perfectly, as only whole shares can be purchased. There will almost always be some cash left after the dividends are reinvested. An ETF with less than $10-15k in it may not drip at all if the payments are monthly and below the price of a single share. So the money that is paid in cash could be deposited in a e-series fund.
Does it make life too complicated for a couch potato? You could limit your efforts to take a look at your cash balance 2 to 4 times a year and still benefit compared to leaving the cash in a money market paying perhaps less than one tenth of a percent in interest. Compounding your returns is important and this is a way to do it with very little trouble, even it there is no guarantee the money will beat the MM’s low return.
One last thing: when the money in an e-series index fund is close to reaching the level that justifies an ETF purchase, you must leave the account without any deposit for 90 days (30 days for the e-bond fund) to avoid an early withdrawal penalty. Life on the couch can be tough…
[…] Bortolotti from the Canadian Couch Potato answers the question: Should You Use Index Funds or ETFs? and offers these Model Portfolios for […]
After the market debacle, I gave up on full service brokers and came out with the following cash positions: RRSP 86k TFSA 10k CAD Savings 21k USD Savings 34k
I am looking at investing in “The Uber-Tuber” portfolio on your site, but modified as follows:
60% of cash would be evenly divided and invested into CLF, CBO and PRF.
40% of cash would be evenly divided and invested into the remaining portfolio securities.
Would this be considered a valid conservative approach and cost effective?
Thanks,
Jack
@Jack: Thanks for your comment. Just curious why you are lumping PRF (an equity fund) with CLF and CBO (bond funds). What is the total percentage you want in fixed income?
Sorry, the allocation of cash to fixed income (CAD/USD) should be 60%, thanks!
Thanks for the breakdown, but back to my original 2 questions. “Would this be considered a valid conservative approach and cost effective?”
Thanks again,
Jack
For a neophyte, what would your recommendation be if i wanted to move $250,000 from RRSP with high fees to RRSP with low fees?? Index or ETF? Which ones?
Thanks!
@Cathy: In terms of cost, there is definitely an advantage to using ETFs in a portfolio that size. However, as always, it becomes expensive if you’re adding money to the portfolio every month. As long as you keep your trading costs down, and as long as you’re comfortable buying and selling on an exchange, then ETFs are the way to go. See my Model Portfolios page for specific suggestions.
Agreed that couch potato can get a good 60/40 or 70/30 asset allocn if EQ/Bonds and then you want to hold it for 15-20 years with yearly rebalancing. So if one wants to invest 50,000 CAD today, what are the options?
Given that bond ETFs are at a high – e.g. XBB at 30.33 and equity ETFs are at a low e.g. XIN at 19.88 on 17th Oct, does it not make sense to buy your equity ETFs now in 1-3 months. Then buy your bond ETFs when they are at a low in 3-12 months. So your EQ/BOND ETF allocation % of 60:40 is still reached in 1-12 months but at a good going in price.
Is timing of buying your ETFs – eq or bond important in addition to the asset allocn you want to target at the end of the year? Waiting to see your & the readers comments. Thanks.
@Mary: It sounds like you’re trying to time the market. It would be great if we knew where XIN or XBB might be headed in the coming months, but no one can predict that.
Good feedback. So if I am buying the XIN, XBB, etc as part of the couch potato ETF portfolio below, I should buy them at same time.
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%
But you mention there a minimum amount of CAD 27K or 40K needed to breakeven on the MER. Does that mean that for a CAD 40-50K principal with a $19.99 trade fee,
a. Do I need to buy the 5 ETFs on the same day or with in a week or a month?
b. Is dollar cost averaging over 3 months not advisable by making 3 trades (1 per month) to buy a fund vs 1 trade (in 3months) ?
c. Is there a time of the year – Oct or Dec or June when one should re-balance.
Waiting to see your & the readers comments. Thanks.