Index Funds VS. ETFs

by Mike Holman

As a low cost investor I like researching different low cost options and trying to decide which is best for my situation. One question that comes up frequently from investors with small portfolios is whether they should buy low cost index fund such as the TD e-series or by ETFs which have lower mers than the index funds but you have to pay a minimum of $4.95 per trade. Other blogs have covered this topic and based their answer mainly on the portfolio size. If your portfolio is significantly less than $25k then start an account at TD and around $25k mark, transfer it to a discount broker like Questrade and buy ETFs. This is definitely the cheapest strategy but it involves setting up two accounts and doing one transfer.

One problem with that method is that I suspect a lot of investors will set up the account at TD but they won’t switch to a discount brokerage at the right time or at all which means in the long run they will end up paying more fees compared to if they had just started buying ETFs even when the account was fairly small.

Questrade Democratic Pricing - 1 cent per share, $4.95 min / $9.95 max

To avoid this problem I would suggest that another strategy to consider is to pay the higher costs of a discount brokerage right from the beginning because it won’t be long before you will be saving money and can recoup the extra expenses from earlier on. What I did was to set up a model which will tell me if an investor has a small portfolio then how much money per month do they need contribute to make this strategy worthwhile. There is a link to my spreadsheet at the bottom of the post.

Another part of this idea is to start with Questrade because it’s the cheapest discount brokerage available but alter your trading habits – if you contribute monthly then only buy one ETF per month. Another great idea is to only buy an ETF every second or third month, especially in the beginning.

What we are really looking at is the idea of doing either TD or Questrade and seeing how long it takes for the break even point to occur. If the point is fairly soon (ie less than 5 years) then it might be an idea to just go with the ETFs if you don’t think you will make the switch from TD to Questrade down the road.

This chart indicates the final numbers. The second row has the portfolio size, the second column has the monthly contributions and the other numbers are the number of years until the break even point. Keep in mind that the break even point is when all the losses in the early years are made up for.

For example if you have a starting portfolio of $10k and you contribute $250 per month then after eight years the total costs of ETFs (for all eight years) is the same as the cost of index funds.

 

 

Portfolio size

 

 

 

 

$0.00

$10,000

$20,000

Contribution

$100

30

13

4

 

$250

13

8

3

 

$500

8

5

2

 

$750

6

3

1

 

$1000

4

3

1

 

As you can see, the monthly contribution is a big factor in this decision – if you are contributing larger amounts then even if you start with nothing, the Questrade option is better. Another factor of course is the starting portfolio size – if you already have $20k then it’s probably better to start at Questrade . The reverse of course is true – if you are contributing $100 per month then you are probably better off with TD unless you have close to $25k.

This is definitely a personal decision but I would think that unless you are super keen to save every cost possible then consider doing Questrade from the beginning if the break even point is less than about 5-7 years.
Keep in mind as well that a lot of the initial trading costs can be saved by contributing to the Questrade account monthly but only buy ETFs infrequently.

I’m also using a very simplified portfolio that is equally weighted among the securities. If you want more securities that are not equally balanced then that may add to the trading costs with the Questrade option. Even there if you want a small emerging market exposure you can just make one purchase a year for example in that class. You might not have your desired asset allocation at all times, but if you portfolio is very small then that probably doesn’t matter that much.

This analysis assumes that you value low costs above convenience – one big advantage of an index fund is that you can set it up to take the money from your account and make the index fund purchases automatically. This can’t be done with ETFs so you have to login every month and make a purchase.

Conclusion

If you are a big contributor with a small portfolio and are keen (but not superkeen) to save costs then it might make sense to start at a discount brokerage instead of at TD and then switching.

I suspect for a lot of investors however it might make sense to just go with TD and only switch over when they have a significantly large amount say over $50k. Another plan might be to accumulate $50k or $100k at TD and then transfer to Questrade if they will pay for the transfer costs. Meanwhile you keep accumulating at TD.  The choice between index funds vs ETFs is not an easy one.

This is the spreadsheet I used.

More information

Should I Buy ETFs Or Index Funds?

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{ 25 comments… read them below or add one }

1 WhereDoesAllMyMoneyGo.com

Nice post Mike! I’ve been meaning to write a post on the importance of investor behaviour versus product/platform selection, and this post is an excellent example of how this can be very important.

Similarly to the debate between active/passive – I don’t think that is as important as being able to stick to your plan.

Preet

2 Four Pillars

Thanks Preet – I was thinking the post started out with a good idea and turned into a bit of a disaster!

The more I thought about it, the convenience of index funds is probably worth enough to most people that they are probably better off with index funds until the cost difference is significant (ie maybe $150/yr after trading costs).

Sticking to the plan is definitely the key.

3 Mr. Cheap

Great post! I suspect you’re right that people start off with the ideal of “I’ll switch over once I have enough” and then never actually make the switch. I’m with E*Trade, and paying $20 / trade (which is very expensive these days), but I just can’t bring myself to go through the transfer (I’m convinced there’ll be problems).

4 Cheap Canuck

Thanks for the great article. So far I’ve been investing with index funds through a e-fund RRSP. However, I have been mulling the possibility of switching to a self-directed RRSP, and at that time might make the switch from index funds to ETFs. I wrote a post this morning that obliquely references index funds vs. ETFs. Do you mind if I link to your post so readers can get a more detailed comparison if they choose?

5 Four Pillars

Cheap Canuck (boy, that sounds familiar…)

You can link to any post any time – no problem.

I think I’m going to have to do a followup post to this one since I kind of changed my mind several times during the writing.

Mike

6 telly

Lol…Mike, I could tell. You changed my mind several times as I read it as well. ;)

I admit, though we’d be better off moving our e-funds over to Questrade (where we have an unregistered account), we haven’t gotten around to it yet.

In fact, part of me thinks moving everything over to a self-directed account at TDW sounds like the easier option (although we’re not quite at $200k for discounted trades).

7 MillionDollarJourney

telly, tdw only requires $100k for $10 trades.

8 telly

Thanks FT. What’s funny is that I was just looking through some of your old posts and found that just now!

Unfortunately that’s not going to cut it either for now. Too much of our investments are in 401k’s so it’ll likely be a bit before we get to having $100k in Canadian investments.

Thanks for correcting me though!

9 Slim

I just closed my account with Questrade.

– They go ‘down’ at the worst times (during the middle of the trading day!)
– customer service is horrible (go ahead and call their number and see if they actually pick up!!)

10 Four Pillars

Telly, with less than $100k then TD efunds is probably just find.

Slim – sorry to hear about your problems with Questrade. I haven’t experienced any problems but I’m also not a frequent trader.

Mike

11 mariam

I’ve been holding off on switching to ETFs for awhile because I’ll be triggering capital gains so I’m trying to offset with some losses. Shouldn’t be hard :P

12 Four Pillars

Mariam – capital gains are a consideration that I didn’t think of because I was assuming assets with an rrsp. I’ll have to think about this but that changes the equation quite a bit.

Mike

13 Transcanada

It’s been a while since I’ve bought ETF’s but if the goal is to invest regularly and keep transaction costs down why not consider an Income trust with a drip (distribution re-investment plan) and a unit purchase plan.

I know TDW will set up a drip within your brokerage acct. Other brokers offer the same.

My preference is IT’s due to yield but the sector is beaten up so do your own due diligence.

Also some IT’s offer a nice discount to purchase within their Drips (you must enroll directly with the Trust in some cases) .

PMT.UN for example offers a 6% discount on units purchased. Same deal if you buy additional units. the 6% discount applies.

Anyway, starting out 6% below market price is a nice edge to have although that isn’t enough if the market is moving the wrong way so be caustious if you don’t like volatility.

Cheers TC

14 Four Pillars

Thanks TC. I’m not a big fan of income trusts personally. I think they are a fairly good tax efficient way to do withdrawals but for someone in the accumulation phase I don’t think they are the best option.

Mike

15 Mr. Cheap

TC: I don’t have any problem with Income Trusts, but I don’t think they’d be a reasonable substitution for a broad market ETF / Index Fund. Something like EAFE is FAR more diversified (many businesses in many industries in many countries on many continents) than any income fund you might find.

This isn’t to say ETFs are “better” then income trusts (or vice versa), they’re just very different (and will appeal to different investors or fulfill different objectives in portfolios).

16 telly

“Telly, with less than $100k then TD efunds is probably just find.”

Mike, the reason we’re considering moving to ETFs is because the amount in our RRSPs is made up of basically one fund (TD CDN index efund) as our 401k’s make up the rest of our assest allocation. Even $25k would be better in an ETF if it’s only in one fund I would think.

I think we may look into transferring them to Questrade sometime later this year as I really like the idea of USD RRSP contributions as well.

17 Four Pillars

Telly – I think you are right – $25k is better in an ETF.

18 dj

TD Waterhouse would seem like the perfect discount broker choice for someone wanting to use eFunds and ETFs

19 Four Pillars

dj – You might be on to something.

I’m not sure however the connection between their discount brokerage and the e-series funds. I don’t think you can buy the e-series funds from the brokerage so you would still have to transfer the money at some point – but that would probably be easier than switching to a different company.

If anyone is more familiar with TD’s setup then please let me know.

Mike

20 dj

in fact 1 of our accounts at TDWH has monthly contributions going into 3 eFunds. They refer to it as a SIP, systematic investment plan.

21 Potato

Yep, you can buy the e-series mutual funds right from your TD discount brokerage account. Just go to order entry -> mutual funds, and put in the fund code (e.g.: TDB900 for the Canadian Index Fund).

22 Four Pillars

Thanks for the info.

However if I’m not mistaken the TD account will have annual fees for rrsps unless over a certain amount?

I thought the fee-free version was the mutual fund account which is separate.

Mike

23 Brad Davis

Is it really necessary to go all ETF’s or all Mutual funds? I prefer to look at each contribution and use the most appropriate vehicle. Check out this graph which compares the two:

http://www.enrock.net/wordpress/2008/02/08/should-i-buy-a-mutual-fund-or-an-etf/

24 Four Pillars

Brad – no it isn’t. I have another (hopefully much better) post on this topic which clarifies this.

Mike

25 rooban

Slim- I am with you on Questrade going down. I have been with them for around a month now. They do go down in the middle of the day sometimes.. and I tried calling their customer service, they don’t pick up the phone. I am losing money here.. if it happens again.. I will be forced to take my accont to somewhere else…
I tried doing Transfer Positions from one account to another. As soon as the transfer completed, I checked my transferred positions, voila.. their avg price has been jacked up on its own – which means the profits have gone down …what the heck.. I am going to call them tonight and fight with them.. this is ridiculous..!

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