Responding to a recent article on mutual funds by Rob Carrick, a Globe and Mail reader rehashed a common refrain: “Perhaps mutual funds were once a great way for ‘average Canadians’ to invest, but they have been totally subverted by the greed and mediocrity of the financial institutions who dominate the field … Canadians are generally far better served by ETFs.”
The problem with remarks like this is they present the debate as “mutual funds versus ETFs,” and that’s the wrong way to think about it. The mutual fund industry in this country has enormous problems, to be sure: some of the highest fees in the world, deferred sales charges, and bad advice from salespeople with vested interests. These are all disgraceful practices, but they have little or nothing to with the mutual fund structure.
Index investors have broken free of the worst industry practices, but they still seem reluctant to embrace mutual funds. For example, when Scotia iTrade began offering Claymore (now iShares) ETFs without commissions, I heard from many folks who couldn’t wait to get on board. Many chose to ignore—even after it was pointed out to them—that most of the commission-free ETFs were far more expensive than the TD e-Series funds, and they were remarkably close to RBC’s family of index funds, which have always been available through iTrade and other brokerages.
Where mutual funds have the edge
In many cases, ETFs are dramatically cheaper than comparable index mutual funds. But when the MER differences are less than 20 or 30 basis points—especially with small portfolios—mutual funds may actually have an edge, even if the ETFs are commission-free. Here’s why:
Preauthorized contribution plans. The key to investing success is disciplined savings—indeed, this matters far more than small cost differences. And for most people, the best way to enforce that discipline is to set up preauthorized mutual fund contributions. Yes, you can set also up automatic cash contributions to your brokerage account and buy ETFs manually, but many people simply don’t have the discipline to do this in a systematic, unemotional way. Those who don’t have access to commission-free ETFs may even let cash build up to minimize the number of trades they make. That will save a couple of $10 commissions, but the uninvested cash also causes a drag on returns.
Reinvestment of dividends and interest. ETF investors—not to mention those who buy individual stocks—seem to love dividend reinvestment plans (DRIPs) and speak about them as if they’re a magical form of compounding. But the fact is, mutual funds are far more efficient when it comes to reinvesting distributions: every cent stays in the fund because you can purchase partial units, so you benefit from compounding immediately, no matter how much you have invested.
Lower transaction costs. Experienced investors understand you can buy and sell index mutual funds without trading commissions, but that’s not the whole story. Remember too that mutual funds trade at their net asset value, which means they do not have bid-ask spreads. While most ETFs keep their spreads tight, not all of them do, and every buy or sell order comes at a cost, even if you’re using a brokerage that offers commission-free ETFs.
One reader recently asked me whether the appearance of commission-free ETFs made the TD e-Series “obsolete.” I’d answer with an emphatic no. ETFs are the best thing to happen to Canadian investors in decades, but they’re not always the right tool. For regular savers with modest portfolios—especially those who value simplicity and convenience—index mutual funds remain a better choice.
Great post. There is definitely a place for both ETFs and mutual funds. While most of my portfolio is in ETFs, I do use index mutual funds to handle monthly contributions until they get large enough to use to rebalance – generally I wait until I have at least $1000 or so as the $10 commission eats up too large a percentage of smaller trades.
The flip side of the discussion is that there is nothing inherently beneficial about ETFs either. There are ETFs that are leveraged, reverse, actively managed, and only invest in extremely narrow sections of the market. Of course, these tend to come with high fees as well. Just because it is an ETF does not make it a good investment.
@CCP: again, another spin on what seemed simply cast in stone for us (“ETF’s are way more efficient — Mutual Funds are not”), reminding us that just as we think we’ve learned all we need to learn, there is always some new subtlety to grasp! Keep ’em coming Don!!
BTW, is there soon going to be a review of the merits of Preferred Share Funds? (I believe you hinted that there might be).
I think mutual funds have a cash drag as well. They have to keep a small percentage of the fund in cash to deal with redemptions.
I would buy index mutual funds if their fees were competitive, but mostly they are not. Is there a reason why there is not a mutual fund version of XIU that charges about the same MER (0.18%)? I’ve always wondered if mutual funds are inherently more expensive than ETFs.
Great post! I believe there’s a place for index mutual funds even in bigger portfolios.
There are plenty of people out there that don’t care to purchase ETFs or are intimidated by brokerages. Some are just happy to buy low-cost index mutual funds, and pay a little bit more in MER for the simplicity.
Personally, I think if Canadian’s have access to ultra low cost index mutual funds, similar to the Vanguard index mutual funds that are available to Americans, we’d be talking a lot less about ETFs.
Thanks for the article. To me, mutual funds are still trying to come to grasp with their multitude of problems created when ETF’s hardly existed. Now they must face the reality. TD has done a better job. Td will re invest my ETF distributions, and I don’t really care if some cash stays in my account for a while. In my humble opinion (0.18% to 0.35%) is really hard to beat! And, the ETF choices are unbelievable!
@Smithson: “I’ve always wondered if mutual funds are inherently more expensive than ETFs.” I’ve wondered the same thing, and the answer seems to be yes. In the US, Vanguard’s ETFs are just one share class of their mutual funds, so that would be the best place to examine this question. And the mutual fund versions are a bit more expensive than the ETF versions.
@Ken: “Personally, I think if Canadian’s have access to ultra low cost index mutual funds, similar to the Vanguard index mutual funds that are available to Americans, we’d be talking a lot less about ETFs.” Absolutely. If I lived in the US, I would probably use Vanguard mutual funds rather than ETFs. It’s possible to build a portfolio in the US for less than 20 bps. Meanwhile in Canada, unless you have access to the e-Series, the cost is more like 70 bps.
One thing many people don’t mention is that in taxable account, MFs can be quite tax inefficient when compared to ETFs that track identical indexes. This is because as MFs grow and shrink, capital gains are realized as the fund raises cash to redeem units. This capital gain is distributed as income.
Any discussion of relative merits of MFs and ETFs in taxable accounts that leaves this out is missing a very important factor.
Good article. There is a huge range of expense ratios in both the mutual fund world as well as the ETF world, so it’s just not accurate to say that one is cheaper/better etc than the other.
@Andrew F: That’s true in theory, but in practice I’m not sure there are huge differences. Unless an index mutual fund experiences massive redemptions, they are usually able to keep capital gains distributions to a reasonable level. And on the other side, a lot of ETFs have distributed significant capital gains because of index reconstitution, currency hedging, and other factors.
CCP, if an ETF and an index MF track the same index, any index changes/forex costs will be in addition to capital gains realization due to fund redemptions. In this case MFs are strictly worse than ETFs, all else equal.
I agree with your premise that not all MFs are to be avoided. Just the vast, vast majority. TD’s e-series are the exception that proves the rule. And TD tries very hard not to sell them to investors… TD is no Vanguard.
I also agree that there are some bad ETFs out there.
I’m honestly still not convinced as someone who is a regular saver. Drips are overrated, and as a young investor, I only buy ETFs that will be sold near retirement in 30~ years (spread rendered somewhat irrelevant). Are there any other advantages to, say, e-series index funds? 0.18 vs 0.35 adds up over time…
I’m a young investor with a small portfolio (under $10000). I currently use the TD e-series in my TFSA, but I also have an account with Questrade. I wonder when it would make more sense to switch over to ETFs since now it’s free to buy them at Questrade when the difference in MER is 0.17%. Or should I have a combination of e-series and ETFs? I’m not using the room in my RRSP yet as my income is still too low for it to be worthwhile.
With my small portfolio, I know that I won’t have enough for DRIPs so it’s nice that the e-series does it automatically. However, I wish that TDB911 covers emerging markets as well. But I read in your previous article that there is no unhedged Canadian domiciled international ETF yet.
A minor quibble: comparing the fees of the RBC Canadian Index Fund to CRQ isn’t really fair because CRQ uses “fundamental” weighting and the RBC fund is cap-weighted. The cap-weighted fund should have lower fees because the license fees for the index should be less and it should have any easier time following a cap-weighted index (less buying and selling by the fund managers to maintain cap weighting). I do wish that CRQ’s fees were lower, though.
@Mansbridge: If you’re fully comfortable using a discount brokerage to manage a small ETF portfolio and you’re disciplined enough to make regular contributions, then I don’t want to discourage you. I just don’t want people to think they’re making a mistake by staying with the e-Series funds if they prefer.
As for the fees adding up over time, that’s true, but no one is saying you need to stay in mutual funds forever. There is huge value in using ETFs once your portfolio grows large, but in the first, say, 10 years of your accumulation phase it may be trivial.
@Jen: Remember, the difference between 0.18% and 0.35% is $17 per $10,000 invested annually, and that assumes the cost of managing an ETF portfolio is $0. At this stage of your investing life, it is infinitely more important to develop good savings habits than to move accounts to save a few bucks on MER. The same is true when it comes to diversification: the Global Couch Potato is more than adequate for a small portfolio. A 5% allocation to emerging markets in a $10,000 portfolio is just $500. You’re off to a great start: don’t throw yourself of course by trying to do too much, too soon!
@Charles: The different indexes tracked by the RBC fund and CRQ are actually another dimension of the problem. I heard from several investors who were ready to use the fundamental index products without the slightest idea how they worked. Why? Because they were “free ETFs.” I see the same thing all the time with CLF and CBO: these are often available commission-free, so people choose them over broad-market bond ETFs without considering that their risk exposure is very different.
Have you looked at PowerShares RAFI Canadian? Same index as CRQ, but much cheaper:
https://canadiancouchpotato.com/2012/10/01/another-5-underrated-index-funds/
@CCP – “…it is infinitely more important to develop good savings habits than to move accounts to save a few bucks on MER.”
I have no argument against the above statement and believe it is extremely important. However, how might you define “good savings habits”?
Many financial bloggers and advisors talk about “good savings habits” but I’ve had a hard time trying to figure out what that actually is and how it might apply to my personal situation.
Thoughts or links to articles that might help?
@RJM: By good savings habits, I simply mean that you regularly spend less than you earn and you save that difference in some systematic way. For a young person just getting started, tucking away $100 a month with a preauthorized contribution is likely to be a good start. As your income grows, you’ll want to increase that regular savings accordingly.
Debt is also an important factor here. If you’re carrying any credit card debt whatsoever, you shouldn’t even be thinking about investing, let alone sweating the difference between mutual funds and ETFs.
Other than the TD e-series (which I don’t have access to) and the RBC Index funds, are there any other indexed mutual funds in Canada?
I should stipulate, “reasonably-priced” indexed mutual funds.
@Karim: The Altamira index funds are reasonably priced, but other than that, not really. However, Dimensional funds are excellent products—not technically index funds, but certainly compatible with the Couch Potato strategy.
Mawer Balanced Fund would be a reasonable choice as well wouldn’t it?
@Cliffy: I’d say so. It’s an actively managed fund, but you would have to be a pretty ideological indexer to quibble with that choice.
Yes, the big thing with actively managed funds are the high fees more than the active management. Mawer funds are reasonable insofar as they are low cost and not badly managed.
@CPP
“There is huge value in using ETFs once your portfolio grows large, but in the first, say, 10 years of your accumulation phase it may be trivial.”
I know in your “Guide to the Perfect Portfolio”, the guideline was $50,000. Why is there value in ETFs with large portfolios? Is there some disadvantage to having several hundred thousand in an indexed mutual fund? Or are you just referring to more choice among asset classes and inexpensive funds?
@Karim: All I meant was that the cost differences between ETFs and index mutual funds are much more significant with large portfolios. I try to discourage investors from fussing over 10 or 20 basis points when they have $50,000 to invest, because this amounts to $50 to $100. But if you are investing $500k, then we’re talking about $500 to $1,000 annually.
I have a question regarding compound interest. I understand the concept in that if you invest say $100 at 7% interest, the next year the value is 107$ which is compounded again at 7% interest. However, I am not totally clear how this works with long ETFs.
Of course, with dividend payouts, I see how this works in that you get a DRIP or reinvest cash dividends but this does not account for all the compounding interest and especially if you are not constantly buying and selling ETFs.
I read somewhere that this is built into the price of ETFs but could someone explain how??
CCP, what do you think of presidents choice financial portfolio index fund packages they offer that are rebalanced for you with an mer of 0.9percent?
@Mark: Capital gains compound in a similar way, and these gains are reflected in the higher price of the ETF. If you assume that an ETF trading at $20 enjoys capital appreciation of 4% a year and pays a 3% dividend, the value of the ETF will rise to $20.80 per share, plus you will $0.60 in cash per share. If you reinvest the dividend every year, your holdings will compound at 7% annually.
This is the same way a house appreciates in value. Home prices may rise 5% a year, and this growth compounds. So if your house is worth $200,000 today, next year it’s worth $210,000, and the year after it’s worth $220,500. An investment does not need to generate income in order to compound.
@Eric: I wrote about this some time ago, but I’m not sure if anything has changed:
https://canadiancouchpotato.com/2010/10/08/index-funds-from-pc-financial-no-thanks/
Ok, that makes sense but what if the following happens. Over 20 years, the ETF prices is exactly the same price is it was once I bought it. Therefore no capital gains and only the dividends over that period. How has this been compounded?
@CCP:
With accounts over 50k, PC financials offers Premium Class units of CIBC’s index funds with lower MER 0.4-0.5%.
Even with accounts under 50k, since the index funds are rebalanced with global of about 1% (after the rebate), their offer seems similar to ING direct streetwise funds but with more choices for asset allocation.
http://www.banking.pcfinancial.ca/a/products/mutualFunds/portfolios.page
@Mark: Well, if your investment has no capital gains (and no income) over 20 years there will be no compounding. But why would you expect an investment to show zero gains over a 20-year period? At some point your argument is tautological. You’re just stating that an investment that never grows will never grow.
@CCP: Unless I have misunderstood, the Premium Class funds require a $50K investment per fund, not per account.
@CCP:
That’s what I thought too if you buy the funds from directly from CIBC, but on PC financial’s website it says:
“competitive management expense ratios (MERs) or access the premium class, which has an even lower management expense ratio for accounts with balances of over $50,000”
http://www.banking.pcfinancial.ca/a/products/mutualFunds.page?refId=sidenav
Considering their portfolios have 6-7 different CIBC index fund in them, I would be surprised if they require a balance of 300k to get the Premium Class discount.
@CCP No, I don’t mean it will never grow. It could go up 7% one year, down 5% the next year and so on. I’m just wondering that if there was a massive bear market and the ETF value dropped down to the point that I originally bought it at, would there be compound interest over that time?
@Mark: Perhaps your question is about terminology “how is compound interest calculated?”. Go back to CCP’s original concept of thinking of an ETF like a house. If you buy a house for 100k in 2000, and, say, over the next 10 years the valuations (appraisals) are 101, 103, 105, 107, 110, 114, 118, 95, 104, 110 and 115k (the last value in 2010). That is, in 10 years the house value has risen to 115k (with zig-zags in between). 15k increase over 100k is 15% growth in value in 10 years.
Plug this into your compound interest calculator and you get 1.407% per annum compounded annually. If you had rented this out, you could add the rent (=dividends) minus costs and taxes to your investment return calculation. Of course, in this analogy, there is no equivalent of DRIP, unless, with the rent money you bought appliances, furniture etc., so you could charge a higher rent, in effect raising the value of your rental property. ETF’s can be calculated similarly.
@CCP:
I called PC financial today, their premium discount requires 50k PER FUND, so I their offer seems a bit lest interesting now.
I still think it is a good alternative to ING streetwise mutual funds with a similar MER (with the rebate) for the regular class funds, and auto-rebalancing twice a year.
What do you think?
@Jas: Personally I would prefer the e-Series funds, but I wouldn’t argue too strenuously with anyone who was attracted to PC Financial offer.
@Mark: It may be that your confusion arises from the misconception that you read into the description that ETF’s have compound interest built in to them. This only refers to how you evaluate your profit if they grow in value like you hoped they would. Normal Equity ETF’s (the ones dealt with in this blog) track an index, usually of run-of the mill stocks in a given market, and they don’t undertake to guarantee an interest, compound or otherwise. Some pay substantial dividends, others don’t. And apart from special ETF’s that have complicated return of capital or forward exchange swaps, etc., there is no other return on investment. (Bond ETF’s do pay an interest component in their return, but this is not likely to be the source of your confusion).
An ETF, like a mutual fund, is just a tool. One is not better than the other, they are simply different. The biggest thing is that fees are not bad… as long as you are getting the appropriate amount of risk mitigation or excess returns. I would gladly pay a 5% MER if it gave me exponentially higher returns and less risk. The best example I have is CI Signature High Income Fund. MER of 1.6, amazing performance and low volatility. I think the thing that scares the most is a index ETF being traded actively by an investor, which seems to happen more and more these days. I think the majority of people would benefit from thinking about tax efficiency of their return over that extra 1% return
@Mark: Hopefully this doesn’t sound condescending as it is not meant to be, but your confusion might come from a combination of a) misunderstanding the difference between compound and non-compound interest and b) the way that people often refer to processes that effectively act just like compound interest AS compounding. I’ll see if I can show some examples to distinguish them.
Regarding non-compound interest, I don’t know of any investment vehicles that really return interest this way, so most people are not really familiar with it. The basic idea is that every term that interest accrues, the interest is only accrued on the initial investment. For example, if you placed $10k in a savings account paying 4% interest, at the end of year 1, you would receive 0.04x$10k = $400. At the end of year 2, you would again receive $400. That is non-compound interest, and probably sounds weird because it is. To achieve this in real life, the bank would have to do something odd like stipulating that the interest payments to you will go into a secondary account with 0% interest so that the principle in your first account never increases. That would simulate non-compound interest, and as I describe below is not so weird in the stock/fund investment world.
In practice, banks instead put the interest payment back into the same account as the principle, so that after year 1 you have $10,400 in your account. As a result, at the end of year 2, your interest payment is .04*$10,400 = $416 which is larger than your year 2 payment in the non-compound situation. As a result, you tend to make more money in compounding scenarios than non-compounding; if you left your money in the account for 10 years, with non-compounding interest you would make $10k x .04 x 10 = $4,000, but with compounding interest you would make $10k x (1+.04)^10 = $4802.
Now, regarding other investments that behave like compound interest accruals, here’s how I’m picturing things. Let’s just picture one company’s stock that may have a capital gain/loss component (i.e. each share may increase or decrease in value), and a dividend component (i.e. for each share, you receive a yearly cash payout).
Looking at dividends at first, let’s suppose you have $10k invested upfront in the stock, and in the first two years there is no share value change, $10k worth of shares remains worth $10k, but the dividend payment is 4% annually. If you do not have a Dividend ReInvestment Plan (DRIP), at the end of year 1 you will receive $400 in dividend payments and it will likely end up in some cash component of your portfolio, or you may even literally receive a cheque in the mail. Assume you just sit on the $400 cash going forward – your total holdings in the company remains $10k, so when the 4% dividend is paid out in year 2, you again just receive $400. You’ve just mimicked a 4% non-compound interest savings account like the one hypothesized above and, at least until recent years, I think this was the default scenario when receiving dividends.
However, if you set up a DRIP so that dividends are reinvested, then at the end of the year you automatically buy another $400 worth of stock with your dividend payment (assume you can buy partial shares or $400 buys a whole number of shares). You now hold $10,400 in the company. At the end of year two, your dividend payment is .04*$10,400 = $416, the same as the compounding savings account discussed above. In that sense, dividend payments compound if you have a DRIP plan or at least manually reinvest your dividends.
In the dividend example above, there was no share value change. So, what if there was? Well, supposed now there’s no dividend payment (i.e. dividend yield = 0%), but the stock appreciates in value 4% each year. This time, at the end of year 1, your $10k in holdings themselves have grown to $10,400. In year two, they again appreciate in value 4%, i.e. they grow by another $416 just like the compound interest savings account. Share price appreciation, unlike dividends, is therefore inherently compound. The only way to achieve a non-compound capital appreciation would be if there was a stipulation that any value accrued had to be sold off for cash right away, e.g. so that at the end of year 1 you had to sell $400 worth of your stock to get back down to a $10k holding. That $400 would then go into a cash account with no interest, and in year two your appreciation would only be another $400. This would be simulating the non-compound interest account from the first example.
Finally, you had a question earlier along the lines of how could an investment that is described as compounding show no overall change in value over some long time period? The crux of the answer to this might be just to remark that whatever %value change happens in a given year is applied to the current holdings, not the original investment, and that fact is not changed by the investment sometimes losing value and other times gaining. E.g. if in year 3, your investment from the previous examples loses 5%, that loss is applied to the total holdings you had at the end of year 2, not your original $10k.
For example, suppose you put $10k in a fund that proceeded to return +5%, -4.5%, -5%, and +5% in the first 4 years. In a real-world scenario where the changes compounded, you have about $10,002 at the end of 4 years, almost the same as you started with, even though things were “compounding”. So, compounding doesn’t mean you always make money. And, as Oldie pointed out, total returns over a long period are often summarized as average annual compound return, basically answering the question “If this money had been in a savings account accruing compound interest, what interest rate would it require to produce the same change in value?” In my example, to invest $10k and find yourself with $10,002 at the end of 4 years would require a savings account with 0.005% interest, i.e. $10k x (1+.00005)^4 = $10,002.
Hope that helps.
I like the global neutral balanced index funds – the products offered by TD and CIBC (PC) that keep automatically rebalanced and have the features mentioned above like automatic SIPs and DRIPs all for just over 1%.
They could be particularly useful for many, particularly smaller, accounts because they are “one stop shopping” and “set and forget” with the only decision being how much you want to contribute each year.
Another place index mutual funds are commonly available is in Defined Contribution pension plans. ETFs are not offered by many plans. Given the very low MERs charged by BlackRock et al for some of these corporate DC plans they are a very good investment choice.
Today I opened another account at TD Waterhouse. This time it’s an informal trust for my daughter. There are no fees, minimum account balances, or inactivity fees when the paperless option is chosen. I plan to build a small global couch potato portfolio with the e-series funds, again no commissions. I originally investigated the smaller brokerages but both Questrade and Virtual Brokers have fees that pop up at some point considering the account size. 2 years ago when I started investing I only used the e-series funds and would strongly recommend them to others. I think these funds have practical utility beyond 50k portfolios if you plan to contribute/and or re-balance more than twice a year. Also, as Dan wrote in an earlier post etfs can be used in conjunction with the e-series funds eg complete couch potato, emerging markets and REITS. No sales pitch from the TD advisor either:) she remembered me from last time.
@Simone @Oldie Wow, thanks so much for your explanations. Makes a lot more sense and just trying to get my head around all of it.
If contribution is made every month to couch potato portfolio what is a proper way to calculate return on investment at the end of the year? What if the same contribution pattern is repeated for several years, what would be the proper way to calculate compounded annual return? Assuming all asset classes are kept in balance every time purchase is made.
Another advantage of mutual funds: Since mutual funds have automatic reinvestment of dividends and interest, it is easier to keep track of the adjusted cost basis inside taxable accounts.
http://canadianfinancialdiy.blogspot.ca/2007/03/adjusted-cost-base-for-etfs-and-mutual.html
@Gordon: This is a great question, and one that is often underappreciated by investors. It is actually quite difficult to calculate your rate of return when you have cash inflows (or outflows). You need to use a method that accounts for these cash flows, such as the Modified Dietz method. Justin Bender has created a spreadsheet to help:
http://bit.ly/116988D
@Jas: It’s especially important to note that using DRIPs with ETFs makes calculating your adjusted cost base something of a nightmare!
Let’s say you started at $1000 using Virtual Brokers (0.99 per trade), and managed your index portfolio, wouldn’t the cost of every transaction (buying or selling), cost you overall more money than your profit?
Great article and follow-up discussions. Regarding the ability to setup preauthorized contribution plans with mutual funds, don’t some ETFs, for example iShares, now have PACC Plans that also allow the automatic purchasing of iShares ETFs on a regular basis without incurring additional trading commissions? However it seems not all brokerages support ETF PACC plans yet but it may just be a matter of time especially if we all ask our brokers about it.
http://ca.ishares.com/topics/drip_pacc_swp.htm
@Bill: If your portfolio is $1,000 there’s no way you should be anywhere near ETFs. I would just use something like the ING Direct Streetwise portfolios until you’ve built up a more substantial account.
@John: iShares inherited the PACC arrangement when they bought Claymore, and my guess is they’ve grandfathered it reluctantly. As you say, few brokerages support it and it’s really not very practical.
I just read about TD E-Trader, would playing around with their index funds, better or worse than ING Direct Streetwise portfolios? Because trading is free between funds.