[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.
@Potatoe: Thanks. Your answers as the Cdn Capitalist are usually very straightforward and easy to follow…for those of us not aspiring to be the Kevin O’Leary’s, just a the most comfortable retirement possible. Although we do play the big cancer and Heart and Stroke lotteries so you never know!
Hello,
I had a question regarding this, if I do a prepayment of $100 every month for each of the 4 index funds (Canadian, International, etc) will the MER automatically be calculated based on how much I invest? because I do not want it to add up for each so 0.5 for each roughly x 4 funds would be 2%
@Peter: The total MER of any portfolio is not determined by adding up the MER of individual funds. If each fund charges 0.5%, the MER for the whole portfolio is also 0.5%.
I was looking at the TD eseries index funds, and noticed the international fund has a currency neutral alternative. I suppose this is hedging the Canadian dollar vs. foreign currency fluctuation risk, which seems like a good idea, but I am a relative newbie so I was hoping to know your thoughts on incorporating the eseries International vs. Neutral International into a couch potato portfolio.
Thanks,
Anne
@Anne: I tend to prefer funds that do not hedge currency, as I think it’s an added expense for a dubious benefit. However, there are certainly periods were it will be beneficial, so if you’re more comfortable with the currency neutral funds, they’re a perfectly good option.
Just to flip this argument on it’s head, with some discount brokers, stock trades are cheaper than mutual funds.
I have a small trading account for my TFSA and I use Questrade as my online broker for that reason.
My stock and ETF trades are only $5 each, and mutual fund trades are $10, but they kick back any trailer fees to your account.
@Mike: Thanks for making a good point. Note that Questrade has the cheapest stock trades in Canada, and it is the only brokerage I know of that charges a fee for buying no-load mutual funds, so I believe it is unique in this respect. At virtually all other brokerages, you’re dealing with the opposite situation.
Guys, Scotia Itrade are offering a series of commission free ETF’s here is the link to the list of ETFs, I am not very familiar with ETFs. Are those any good?
https://www.scotiaitrade.com/pages/quotes/etf_list.shtml
@ Lenny: See my post on this issue:
https://canadiancouchpotato.com/2011/09/13/commission-free-etfs-arrive-in-canada/
I have been making regular monthly contributions and investing in mutual funds through financial service compainies and banks for years. I am think about just quitting that, leaving what I have in those funds but not adding any more and beginning to make my monthly contributions into index mutual funds, starting with nothing of course and slowly building it up one month at a time. I have a 20 year window. make sense?
@Gord: What’s stopping you from moving your existing investments into index funds?
I know the guy, he is a buddy. (I know that is lame) . Does it cost me a penalty to move my money out? I know that each year i leave my money in there he takes MER’s off my money right? (2.76 or something like that.)
@Gord: Whether it costs money to withdraw depends on the type of funds your advisor uses. Many do have deferred sales charges (DSCs) that apply for up to six or seven years. And yes, he’s taking 2.76% of your money every year. That’s $115 a month on a $50,000 investment.
I’m new to your site and thank you for all of your generous advice.
You mention that Americans can invest in cheap index mutual funds like Vanguard (for total market, S&P etc). Is there a reason Canadians cannot?
Also, is there a reason you have such a significant weighting distribution towards Canadian stocks (greater than US stocks) in your model portfolios?
@Jchan: Welcome aboard. Vanguard does not offer index funds in Canada, and all of the index funds available here have much higher fees. Mostly this has to do with a lack of competition and investor awareness.
As for the heavy weighting to Canadian stocks, this is actually much less than most Canadians have in their portfolios. There are some good reasons to overweight one’s own country (currency risk, preferential tax treatment) but mostly it’s just a behavioural bias.
@CCP: Any of Vanguard’s low fee US listed ETFs can be bought by a Canadian through any brokerage firm. Assuming one doesn’t want currency hedging, the only downside I can think of in doing this would be the less than ideal currency exchange rates offered by most brokers, but there are probably ways around that (Norbert maneuver for one).
I am a peripheral investor, but have no pension plan, I have pretty much decided that index mutual finds are what I am going to do from now on, I just do not have the time or information to follow it any closer than that. The ETFs are interesting but I am not sure I want that level of involvement. I am starting investing anew on January 1, 2012, using some type of model portfolio for index funds, I will begin investing about $800.00 a month. tell me if this makes sense? I want the opinion of everyone in the world on this, drop whatever you are doing and respond, my financial future is in your hands.
@Gord…as a fairly regular follower of CCP’s I’d guess he will encourage you to:
1. Educate yourself by reading more articles on blog and others, i.e. links he provides on his site(if you havent already)
2. Look into a reputable financial professional (CCP has listings on his site)
3. Educate yourself – Ive reading and listening whenever I can to credible sources over the last 15 yrs and it’s an ongoing process)
4. By good books like the new Wealthy Barber’s book and of course the CPP’s new book.
I hear what your saying about looking for a fairly low maintenance investing strategy. My partner and I did find one but it took time, effort and ongoing tweaking. Im not sure if CCP and others will agree but we think that with the current and near future world economy it’s best to be willing to keep more of an eye on your investments rather than the old set it and forget it approach.
Good luck!
I am concerned about forex charges when buying a US etf. I have read and greatly appreciated your analysis about when to choose between index funds and etfs. Have you done any calculations to determine at what point it would make more sense to buy a Canadian dollar US mutual fund instead of a US dollar etf to avoid the retail forex charges? I guess a lot would depend on the number of transactions but I would appreciate your thoughts.
@Dave: Your concern is a very important one. These posts may help:
https://canadiancouchpotato.com/2010/01/24/should-you-buy-us-listed-etfs/
https://canadiancouchpotato.com/2010/10/18/are-us-listed-etfs-really-cheaper/
https://canadiancouchpotato.com/2010/10/19/reducing-the-cost-of-currency-exchange/
Hi CCP!
I alwys enjoy reading your blog posts as they come into my blog reader.
I have read your article and many of the comments. As a result I did some figuring and have some questions. I currently have two e-SERIES accounts (mine and wife’s). My account is 40k and my wife’s is 48k.
I have a couple scenarios:
We could combine our acounts and have IShares ETFs through TD Waterhouse. Even with 4 trades every 6 months we would still be over the breakeven point.
Or we could transfer out of TD, and get into ETFs through a no or low cost brokerage (i.e Questrade), and combine our acounts, and be better off still.
I recognize we sacrifice the regular monthly contributions, but to me it seems better to consider ETFs at this point.
Any suggestions would be appreciated.
Thanks
Darren
@Darren: I’m not sure you can simply combine the accounts if they are in two different names—better check into that. Also, do you currently have TD Mutual Funds accounts or TD Waterhouse accounts?
Either way, I would not be in too big a hurry to rush into ETFs. Don’t underestimate the importance of those regular monthly contributions!
CCP,
Thanks for your speedy response. To answer your question, we have a Waterhouse account with e-Series index funds. And thanks for your encouragement to not rush into changing. You confirmed a suspicion I had.
Darren
@Darren: If you’re already with TD Waterhouse I would not recommend switching brokerages just to get the commissions down to $5 from $10. Since you can buy ETFs in your Waterhouse account, you could build something like the Complete Couch Potato using a combination of e-Series funds for the main four asset classes and ETFs for the REITs and real-return bonds.
Hopefully it’s not too late to post a question/comment on thist post: Maybe this is a total rookie question… I understand the MER calculation when comparing ETF’s vs Index Mutual Funds but how do you account for Trailing Commisions on mutual funds. Shouldnt’ that be added to the MER?
@Daryl: The trailing commissions on mutual funds are already included in the MER.
Whether you invest in a taxable accounts or a registered account might also affect your decision.
First,one might prefer truly canadian domiciled funds like TD -E series in taxable accounts for different reasons:
– To make sure you can claim the federal foreign tax credit to recover withholding tax for foreign dividends
– loss of capital gain distributions’s preferred tax treatment, which will be taxed as regular income if you use a US-listed ETF or pseuso-canadian ETF investing in US-listed ETFs (like XWD)
See comments at the end of this post: https://canadiancouchpotato.com/2010/10/18/are-us-listed-etfs-really-cheaper/
Unlike index mutual funds that are truly canadian domiciled (like TD eseries), there are not many true canadian domiciled international ETF .
Also, according to the following post, it seems to be easier to keep track of the “Adjusted cost base” for tax reporting with mutual funds:
http://canadianfinancialdiy.blogspot.ca/2007/03/adjusted-cost-base-for-etfs-and-mutual.html
Taken from the the post above: “Though mutual funds and ETFs are substantially similar in that they pass through capital gains and income to unit owners, there is a particular and important difference when it comes to the reinvestment of distributions. In mutual funds, the reinvestments show up as additional units and a higher adjusted cost base (ACB) for those units but with ETFs they do not. You must keep track yourself of the reinvestments and the higher ACB for ETFs. Otherwise, if you just take your original purchase cost for the ETF as the ACB, you will end paying tax again on the reinvested distribution that you already pay each year when taking figures from the T slips”
I was wondering how frequently I should be rebalancing my index fund. I purchased four of the RBC index funds at 20%/20%/20%/40% and if one performs better than the other, I would like to rebalance to the 20/20/20/40… Right?
Thanks Couch Potato!
@Theresa: In most cases, rebalancing once a year is enough, especially if it’s a small account:
https://canadiancouchpotato.com/2011/02/24/how-often-should-you-rebalance/
This and the model portfolio posts have been favourites of mine. Thanks for doing the math Dan.
TD e-Series MERs have changed a bit but the average MER still seems close (0.476% by my calculations). As of December 31, 2011:
TDB900 – 0.33% MER
TDB902 – 0.35% MER
TDB911 – 0.50% MER
TDB909 – 0.51% MER
@CJ: I agree it’s time to update this post. Not only have the MERs changed, but I think we can all agree it never makes sense to pay $29 per trade anymore!
The new MERs have all been updated on my Index Funds and Model Portfolios pages. The weighted MER of the Global Couch Potato using the figures you list above is actually 0.44%.
I’m confused about one thing here. I understand the goal is to have the lowest cost investment, but is there any reason why performance isn’t considered? I’m very new to this, so I’m wondering if ETF’s could say, significantly out perform the e-series mutal funds and that would totally off set any close MER numbers?
Or, is it really best for me to calculate an investment with your formula above and only switch after the break even point?
I’m just having trouble figuring out why I couldn’t store monthly payments in a high interest savings account and make the 4 trades to the ETF’s at the end of the year.
I’m thinking about a similar investment as the one in your example.
Thanks for proving such an awesome resource.
@Justin: Thanks for the comment. When two index funds track the same benchmark, you should expect their returns to be virtually the same except for the difference in fees. (This is not always the case if one of the funds is poorly managed, but in the case of the TD e-Series and iShares, it’s very close.) The ETFs here should outperform slightly because of their lower MERs: however, the question we want to answer is whether they also will outperform after you take into account transaction costs.
You could save your monthly contributions in cash and make one trade each year, but remember there can be an enormous opportunity cost to that strategy. For example, if you had been saving up your contributions in a cash account this year, you would have missed out on the huge rally we’ve had so far in 2012.
ETFs are wonderful tools, but for investors with less than $50,000 who make monthly contributions, they are almost always a poorer choice than index mutual funds.
@CCC Great, thanks! I didn’t realize they were basically the same fund, just different ways of investing in them.
Last question for now: Is it then suggested to start a tax free savings account and then use that with TD Waterhouse to invest in the e-series index mutual fund? If it’s smart, I’m planning on moving my GIC into that instead, and using that money to invest into this fund.
That the right away about going about this?
P.S. I’m reading your “Good, bad and downright awful…” book which is actually confusing me more :)
@Justin: I’m not sure I can answer your question without knowing your objectives, but yes, starting a portfolio with e-Series funds in a TFSa is usually a great way to get started.
BTW, the “Good, bad and downright awful…” is by Rob Carrick from the Globe and Mail, not me. But I did review it. :)
https://canadiancouchpotato.com/2010/01/30/review-rob-carricks-guide/
Justin,
I think you got it but I wanted to nitpick terminology a bit: it’s not the same fund but rather the same index being tracked by different funds.
http://www.investopedia.com/university/indexes/index8.asp
This blog is excellent for learning. Consider also participating in the discussion on Canadian Money Forums – http://canadianmoneyforum.com/
I agree with CCP’s asset allocation strategies and I’ve selected the e-Series funds with a TDWaterhouse account but only you can decide if that’s right for you.
@CCC Bah! Sorry, Dan. I was recommended this website, that book and a few others and my head is a mess. I was just at the bank getting the groundwork set up for these accounts, it took 2 hours which is madness. Oh well, I have an TFSA, RSP + TFMF ready to roll to start my investing. Now to figure out exactly which funds to invest in…time for more reading.
Thanks for the information again.
@CjOttawa nice I will definitely join.
Thank you for doing a worked example. I face the same decision but in a different jurisdiction.
One point though, we need to consider the impact of spreads on the ETF strategy.
This would increase the cost of re balancing , and could be seen as additional commission to take into consideration.
Hi CCP,
My mother and I currently have actively managed mutual funds. My portfolio’s value is $100,000 and my mother’s is $150,000. I plan on moving my funds to RBC Direct Investing and implementing “The Complete Couch Potato”. I am 30 years old and my mother is 63 years old and will be retiring at age 65.
I know for portfolios of our size that ETFs offer superior value. However, being a new investor I am a bit hesitant to subject my mother’s portfolio to any undue risk as a result of any mistakes I might make executing ETF trades. I was wondering if in her case it might make sense to implement the “The Global Couch Potato” using TD E-series funds. My mother would prefer to make monthly contributions which also favors the mutual fund route. She will also be drawing down her RRSP in 5-7 years time while my time horizon is 30+ years.
Thanks for any insight!
@New Investor: I think you’re absolutely right to avoid ETFs if you are an inexperienced investor, and if you’re making monthly contributions: index mutual funds are certainly a better choice. However, you cannot access the TD e-Series funds with an RBC Direct Investing account. You will need to open an account with TD directly.
Good luck, and feel free to follow up with any additional questions you might have.
Hi CCP,
Thanks for the response.
While I am inexperienced with ETF investing I do feel confident after reading your book that I will be able to pull off the “Complete Couch Potato” ETF portfolio on my own.
The main thing I am wondering is if I am doing my mother a disservice by placing her money in TD E-series funds (The Global Couch Potato) and forgoing emerging market and REIT investments? My thinking is that an easy to manage four asset account would be suitable for my mother who has a 5-7 year investing horizon ahead of her and would prefer monthly contributions.
Thanks again.
@New Investor: Over the long term I would expect a portfolio with REITs, emerging markets and real return bonds to slightly outperform the Global Couch Potato, but that assumes that the plan is perfectly executed. It sounds like your mother is not likely to manage that with no experience, so I think you are absolutely right to keep things simple with the e-Series funds.
Hi CCP!
I am very new to the investment game but have had the opportunity to read several books related to index investing. I just recently set up a TD E-Series RSP Mutual Fund Account and plan to contribute $300/month. I plan to continue this monthly contribution for a 20-25 year period.
I plan to use my age (31) as my bond allocation and the remainder contributed towards equities in each major asset class (31/23/23/23) and would like to re-balance annually by adjusting the bond component relative to my age.
Understanding that ETF’s are more efficient with larger portfolios, would I have to consider altering this index investment strategy over to ETF’s if the total monthly contributions of my e series portfolio exceeds the “$50,000” balance? I have a 20-25 year time horizon and would like to take the most simplified route without having to time my investments.
Thanks so much!
@Gavin: Congrats on getting started with an excellent strategy. If you are using the e-Series funds, there is no urgent need to switch to ETFs until your portfolio is at least $100,000 or so. And, really, even with larger portfolios, the savings will be quite small. Plus, you would have to open a brokerage account and rebuild the whole portfoli0—it may not be worth the hassle. If you are pleased with the convenience of the TD funds, and you are making regular monthly contributions, just keep things nice and simple. Good luck!
Hi CCP,
The difference in MERs between the Complete Couch Potato (0.29%) and the Global Couch Potato (0.44%) using E-series funds is only 0.15%. Does this mean that the E-series funds are actually more efficient because I can add money to them without paying commissions whenever I want to? It seems like with indexed mutual funds my money will always be earning returns equal to the market while with an ETF portfolio my money is sitting idle in a bank account/money market fund while I count down the days until I make a lump sum deposit into my ETF investment account.
Where do you recommend ETF investors invest their biweekly/monthly paychecks before making a lump sum deposit to their investment account on a quarterly or semiannual basis? Maybe a person could “store” his money in an E-series fund and then move the funds to his ETF account later on?
Thanks for the information!
@New Investor: Yes, you are right that by using index mutual funds, it is easier to get your money into the markets every month, rather than saving it in cash and making infrequent lump sum deposits. When you use ETFs, there is no perfect solution to this problem. One idea, as you suggest, is to make the monthly contributions to a low-cost mutual fund, and then redeem that money once or twice a year when you rebalance. The problem is that mutual funds charge early redemption fees if you cash them out before 90 days, so you have to be careful.
If you use TD Waterhouse as your brokerage, you can hold both e-Series funds and ETFs in the same account. That way you can use e-series funds for the core asset classes and ETFs for real estate, real-return bonds, and emerging markets. It’s a useful hybrid approach.
Hi CCP,
Sorry for monopolizing your time! I really appreciate the help.
Which emerging market ETF do you feel complements the four asset E-series portfolio the best? It seems that VWO might fit the bill nicely. For REITs I think that ZRE should be fine as it is used in your complete couch potato.
My last question is what percentage of this ETF/mutual fund hybrid should belong to emerging markets?
Thanks you!
@New Investor: Yes, VWO and ZRE are idea. Note that VWO must be purchased with US dollars.
In a portfolio of 70% equities, you might consider:
15% Canadian
20% US
10% REITs
15% International (developed)
10% Emerging markets
Hi CCP,
I am a Canadian resident and I am in the process of opening a brokerage account with RBC DI. They have requested that I fill out a W-8BEN form. Is this form required if I am going to be holding VTI in my portfolio?
Thanks for the info.
@New Investor: This form tells the IRS that you are not a US resident and it entitles you reduce or eliminate the withholding tax on dividends from US stocks and ETFs. So it’s in your best interest to fill it out. This explanation is from Morningstar: