One of the most common questions I hear from budding Couch Potatoes is, “Should I use index mutual funds or ETFs?” While index funds generally have higher annual costs (MERs), they do allow investors to add and withdraw money with no fees. ETFs have the opposite problem: they can have much lower management fees, but they incur commissions (typically $10 to $29) every time you buy or sell shares. That usually makes them unsuitable for people who contribute to their accounts every month. As a result, dollar-cost averaging with ETFs can be impractical.

There’s no perfect solution to this problem, but a reader in Regina explained that he’s come up with a compromise, and I think other ETF investors might consider adapting it to their own situation.

Donald has $65,000 in his RRSP, and he’s using iShares and Vanguard ETFs to achieve the following asset allocation:

Asset class ETF Allocation Amount
Canadian equity XIU 30% $19,500
US equity VTI 20% $13,000
International equity VEA 20% $13,000
Emerging markets equity VWO 10% $6,500
Canadian bonds XBB 20% $13,000

Donald and his wife recently paid off their mortgage and he’s now planning to supercharge his savings by contributing $2,000 a month to his RRSP. The problem is that Donald’s brokerage, TD Waterhouse, charges $29 for each ETF purchase in accounts under $100,000. (Beyond that threshold, the commission drops to $9.95.) That  would add up to hundreds of dollars a year in commissions if he were to add new shares each month.

Then Donald hit on an idea that would help him minimize trading costs and keep him fully invested, which would allow him to take advantage of dollar-cost averaging. His strategy involves making his contributions to index mutual funds in the same asset classes and the same proportions as the ETFs in his portfolio. Once a year, Donald plans to withdraw the money from the mutual funds and move it to the corresponding ETFs.

Donald’s goal here is to have the best of both worlds. By mirroring his ETF portfolio with index mutual funds, he can set up preauthorized payment plans with each fund, adding money automatically each month with no fees. (While he could have simply made the contributions to a money market fund, that would leave several thousand dollars languishing in the account for up to year, earning next to nothing.) At the same time, he can take advantage of the lower ETF fees, an important consideration in a long-term portfolio.

I think Donald’s strategy has a lot of promise, though he will have to manage things carefully to make it worthwhile. In tomorrow’s post, I’ll look at the math details, and I’ll ask readers to share their own suggestions.