It is hard to argue against a strategy that produces a better return than most investment choices. Data shows that most investors, including the majority of active stock pickers, would fare better in the long run if they just bought a representation of the entire stock market through an indexed Exchange Traded Fund (ETF) or mutual fund.
If you want to invest using an index strategy, you with have two vehicle choices: ETFs or mutual funds. Each has its own set of advantages and disadvantages. How you invest will play a big role on which option is best for you. Over the long-term, management expenses are a huge concern, but there are other factors to consider; for instance, how often do you add money to your investment. Frequent contributions favor one vehicle over another.
The Management Expense Ratio (MER)
The Management Expense Ratio (MER) is the percentage of a fund’s average net assets paid out of the fund each year to cover the day-to-day and fixed costs of managing the fund. Index fund typically have a lower MER than managed funds, but even these lower expenses add up over time. For a $10,000 investment that returns 6% a year, after 20 years the value will balloon to over $26,200 for a fund with a MER of 1.0%, but would be worth over $30,000 if the MER were only 0.33%.
Advantages and Disadvantages
Expense ratios are not the only fees. Some mutual funds charge a sales fee to purchase it or a redemption fee when you sell, but this is not common for index funds. Be sure to understand any fees you may have to pay before you buy a mutual fund. ETFs are purchased through brokers, so there is almost always a commission to make a purchase. Some brokers also have additional fees if you do not maintain a certain balance or do not execute a certain number of trades. Again, be sure to understand all your costs before investing.
Each choice has advantages and disadvantages. Since they are traded like stocks, ETFs can be traded at whatever price you choose (assuming someone is willing to trade with you) at whatever time you choose (assuming the market is open). For mutual funds, you can only place a buy or sell order which will be filled at the price set at the end of the trading day. The MER on ETFs are typically lower than the MER on mutual funds. Most ETFs allow you to buy and sell stock options on the underlying security.
For mutual funds, one big advantage is that you can purchase shares for any amount with no commission. You can automatically invest $50 a week through a Pre-authorized Purchase Plan (PPP), and the full $50 purchases shares that day. For ETFs, not only will there be a commission, but you are not able to purchase fractional shares. When you invest in mutual funds, any distributions are easily reinvested if you choose. For ETFs, your broker may or may not offer a free Dividend Reinvestment Plan (DRIP), and if they do, they may not support fractional shares.
For a cost comparison, let’s compare the iShares S&P /TSX 60 Index ETF (XIU) with the Altamira Canadian Index mutual fund. Both these vehicles track the same index. The MER for the mutual fund is a respectable 0.64%, but the ETF has a MER of only 0.18%. At those ratios, the mutual fund will cost you $64.00 annually in expenses for a $10,000 investment while the ETF will only cost you $18.00. That ignores an advantage for the mutual fund, though. You will have to pay a commission to a broker to purchase the ETF. This is not a game changer if this is a one-time purchase, but what if you make one purchase each quarter? If you use a discount broker and only pay $9.95 per trade, your $57.80 in expenses is not noticeably better than the mutual fund. If your broker charges $29.95, the same four trades per year now cost you $137.80 per year.
In another example, let’s compare the iShares S&P /TSX Index ETF (XIC) with the TD Canadian Index mutual fund (these low expense mutual funds, TD e-series, are only available through an online account with TD Waterhouse) . The expense ratio is much closer at 0.27% and 0.33% respectively. This time we will look at portfolio value after 20 years on a one-time investment of $10,000 assuming a 6% annual return. Figuring a one-time commission of $29 for the ETF, the ETF wins by $334 with a value of $30,354 at the end of the 20 years. That is a pretty easy hurdle for the mutual fund to clear if the ETF investor does have to pay multiple commissions a year for those 20 years, but what if the initial investment is higher? With a $100,000 one-time initial investment, the ETF investor now wins by $3,606. It would require a lot of trades to get the mutual fund option back into the competition. And what if you compare the options in our first example with the wider difference in MER? Well now the difference is a very considerable $27,269 advantage for the ETF.
What Should You Do?
In general, the larger your investment balance, the more important a lower MER is. Some people suggest using a balance of $50,000 as your decision point on whether to invest in mutual funds or ETFs. That is not a bad rule of thumb, but all the data you need to make a decision is available on the internet. Find an online calculator to show you the expenses you pay for mutual funds (works just as well for ETFs). Simply plug in the MER and other assumptions, and you will see your annual expense. To make a proper comparison be sure to factor in the other costs you might incur: notably, commissions. A word of warning: make sure you keep an eye on the MER as it can be changed.