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Ask the Spud: Should I Unbundle My ETF?

2017-12-02T20:46:16+00:00October 10th, 2012|Categories: Ask the Spud, Asset Classes, ETFs|Tags: |17 Comments

Q: What do you think of investing directly in Canadian REITs instead of buying an ETF? It may be possible to achieve similar results without paying the ETF’s management fee. – Philippe V.

ETFs promise broad diversification at rock-bottom costs, but not necessarily in every asset class. Sector ETFs, in particular, still have relatively high fees in Canada. The BMO Equal Weight REITs (ZRE), for example, holds just 18 real estate investment trusts yet carries an MER of 0.62%, including the Ontario HST. The iShares S&P/TSX Capped REIT (XRE) charges about the same for an even smaller portfolio. (Vanguard has announced it will bring out its own REIT fund later this year with a management fee of just 0.35%.)

Since indexing is all about capturing an asset class’s returns at the lowest possible cost, does it make sense to simply buy all (or most) of the REITs in these funds directly and avoid management fees altogether? If your portfolio is very large, it might. But whenever you make a decision like this, you need to do the math carefully. Then you need to consider the convenience factor.

At the most basic level, ZRE’s management fee works out to $62 a year for every $10,000 invested. Establishing the initial position would involve just one trade, or an extra $10 at most brokerages. Buying each of the 18 REITs individually, by contrast, would incur no management fee, but would cost about $180 in commissions. As long as he or she made no subsequent trades, an investor with $10,000 would break even after about three years if they bought the REITs individually, while someone with $30,000 would come out ahead after less than one year.

Unfortunately, it’s not that simple. You also have to consider the following factors:

The number of trades in subsequent years. If you’re saving for retirement, chances are you’ll be adding money to your portfolio along the way. With a single ETF you can do so once or twice a year when you rebalance and incur minimal costs. With 18 REITs, you’ll be trading a lot more. You will still come out ahead if your REIT holdings are large, but it will take longer.

Bid-ask spreads. Investors who trade individual stocks sometimes think their only cost is the commission. In fact, the bid-ask spread usually results in a loss of much more than $10. ETFs also have bid-ask spreads, of course, but making a single ETF trade may result in a smaller loss than buying each of the fund’s holdings individually.

Tracking error. ZRE equally weights each REIT and rebalances semi-annually. If you’re buying each of the REITs individually, you’ll have to make at least 36 trades a year to track the index that closely. You may not be concerned about mirroring the index slavishly, and that’s reasonable enough, but you will need to rebalance your holdings occasionally.

Taxes. If you’re investing in a taxable account (which generally is not a good idea with REITs), holding the individual REITs will allow you more control over when you realize any capital gains. ZRE did distribute capital gains of just over four cents a share last year, which investors would have had to pay tax on even if they did not sell anything.

Convenience. Many investors are willing to pay a modest fee for the convenience of keeping their entire REIT allocation in a single fund. Not only does it reduce the frequency of your trades, it also makes it easier to rebalance your portfolio. Reinvesting monthly distributions is also more efficient with an ETF. In the end, you’ll need to decide what you’re willing to pay for low maintenance. Certainly as one’s REIT holdings gets larger (say, $50,000 or so) and the holding period gets longer, unbundling the ETF becomes compelling. For smaller amounts and shorter horizons, it’s not likely to be worth the effort.

For more about unbundling ETFs, see Norm Rothery’s article on the subject and check out his calculator to run the numbers. Both are now out of date, but Norm’s overall insights remain helpful.