Strategies for ETFs and Index Funds

by Mike Holman

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In my last ETF vs Index Funds post I concluded that I really didn’t know what the best way to approach the decision between buying ETFs (exchange traded funds) or index funds.

I was trying to show that some investors with small portfolios would be better off starting out with more expensive (because of trading costs) Exchange Traded Funds because eventually they will save money, rather than go with index funds first and then switch to ETFs because if they don’t switch to ETFs later on then the index funds will eventually be a lot more expensive.

As I wrote the post however it hit home that my approach was somewhat flawed because ETFs are quite a bit more work than index funds so someone who can’t be bothered doing a transfer to a discount brokerage probably isn’t going to be interested in logging into their discount brokerage account every month or two and buying more ETFs.  Figuring out the best solution to index funds vs ETFs is not a simple process.

So to clear up the whole issue once and for all, I have come up with a brand new strategy which actually applies to anyone – lazy or not! Please delete my last post on this subject from your brain and read on….

A bit of background

Buying ETFs is always a manual process – first you have to log into the trading platform of the discount brokerage. Once you check the current price of the ETF (you need to know the symbol) then you enter an order which hopefully gets filled. It’s not a lot of work and I find it quite enjoyable, but for an investor who wants a hands off strategy then it might not be the best approach.

Buying index funds (or any mutual funds for that matter) on a regular basis is sooo easy. This is the big reason why ETFs will never be as popular as mutual funds – most people won’t do the work involved to buy ETFs. With an index fund you can set up a monthly purchase plan (often called a PAC) to take a set amount of money out of your bank account each month and purchase various index funds in the proportion you want. For example if you want to buy $100 each of TD e-fund bond, Canadian equity, US equity funds every month then you set that up once and from that day on, $300 will get taken from your bank account each month and a $100 purchase for each of those funds will get completed. Unless you change bank accounts or want to change something such as asset allocation or portfolio rebalance, you never have to lift a finger. I’ve recently found out that Questrade is planning to allow regular debits from your bank account which will fund your account on a regular basis. You would still have to purchase the ETF manually however since they trade like stocks.

New (and improved) Strategy

What I suggest (until next week when I come up with something better) is do your accumulation of assets at TD using their index funds and automated purchases, and then once you have enough assets to make ETFs worthwhile, transfer those assets over to a discount brokerage (I use Questrade ). Once the assets are at the discount brokerage then you buy ETFs. The trick is to continue to do your accumulation at TD.

What happens if you already have a fair bit in assets? No problem – put the assets you have in the discount brokerage and buy some ETFs. Then set up the TD account and follow the accumulation and eventual transfer procedure as described above.

Variables

One question you might ask is about the transfer fees to move assets from TD to the discount brokerage. I would say that should be factored into the equation but also to try to get the discount brokerage to pay for the transfer. If you are moving big bucks ie $100k then I think your odds are pretty good of getting some or all of a transfer fee paid for – even to an existing account. Keep in mind that transfer fees for rrsps are generally no more than $150.

The next question is – at what point of accumulation do I move the assets to the discount brokerage? $25k, $50k, $14 million?

The answer is a bit tricky. You have to calculate the MER being paid at TD and the MER on the ETFs that you would buy at the discount broker and also include the trading fees that you will probably incur at the discount broker – but since the trades aren’t going to be very frequent they can almost be ignored.

For example in my last post I calculated a potential TD MER of 0.44% and a Questrade MER of 0.19%. If you ignore trading and transfer costs then it makes sense to move assets to Questrade every month. This won’t work of course because of the transfer fees and hassle – plus it’s just dumb.

What I would suggest is to transfer assets to Questrade at a point when you can either get a free transfer or the difference in MER is equal (or close to) the cost of the transfer. Now mathematically this doesn’t really work out since you should really be transferring money as soon as you have enough that the difference in MER for several years is equal to a transfer fee, but the other cost in a transfer is the hassle of actually doing the transfer so it might not be worthwhile to do it too often.

So using my example of TD MER of 0.44% and Questrade MER of 0.19%, the difference in MER reaches $125 (I’ll assume this is the transfer cost) at $50,000. According to my rule, this is when you should transfer the assets to the discount broker. This is a pretty reasonable rule since for most investors it will take quite a while to get a TD account up to $50k so it’s not like they will be transferring every six months.

Other things to think about

Look at the difference in MERs – in my example I used several low cost ETFs from Vanguard – if you choose to use more expensive ETFs from iShares (for example the currency neutral options) then the MER difference between TD e-funds and the ETFs will be much smaller and you might end up transferring assets at a much higher level (ie $100k or more).

Trading costs – I’m assuming that once you transfer the money to the discount broker, you buy your ETFs (not too many), set up dividend reinvestment plans and then don’t do any more trades.

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

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{ 9 comments… read them below or add one }

1 Mr. Cheap

Interesting post. I’m planning to switch to ETFs/Index Funds once I have the income portion of my finances taken care of. I had thought to just set up TD e-funds, but you make a convincing case that moving the money over to ETFs makes sense once they’ve grown…

2 Cheap Canuck

Interesting strategy, although definitely one for the DIY investor types. All of my RRSP savings are currently in TD E-funds, and I’ve looked at ETFs, but the very slight discount in MER (after trading fees are taken into account) wasn’t a big enough incentive to make the switch at this time. I will definitely be reevaluating as my portfolio gets larger though.

One strategy I am looking at is to keep the bulk of my money in the E-funds, but to switch a small percentage of my investments into ETFs that track a specific index (eg Emerging Markets) that I want exposure to, but TD doesn’t currently offer a relevant E-fund.

3 Kyle

In reality, the admiral share classes of most Vanguard index mutual funds are cheaper than most ETFs and are exactly as tax-efficient. If you don’t need an index fund Vanguard doesn’t supply, I find it hard to believe ETFs would be cheaper no matter how much money you’re investing. The admiral shares of their total stock market index fund charge just 0.07% per year, which is the same as the ETF version. I guess the only advantage to owning the ETF is if you wanted to write options or trade during the day.

4 Four Pillars

Mr C and CC – the differences between the different strategies is not huge but it’s worth looking at once in a while

Kyle – this post pretty much applies to Canada where we have the highest mutual fund fees in the universe – even our index funds are expensive!

5 Alex Givant

FP: Why not to buy the same ETF using TD account, it costs only $9.95 ($5 difference with QuestTrade).

Assuming that you have Couch Potato portfolio (4 ETFs: Canadian, bonds, US, International) and you do the purchase them once a year, it’s $20 difference.

Beside that, TD supports DRIP and I’m not sure that QuestTrade does the same.

Last question: why do you hold money in US ETF vs. Canadian, doesn’t it add currency exchange risk to your investments?

Thanks for post.

6 Cheap Canuck

I believe you need at least $100,000 in your TD account or be performing a large number of trades quarterly before the 9.95/trade rate applies. Otherwise it is $29 per trade.

7 Four Pillars

Alex – Cheap Canuck is right – you need $100k at TD to get $10 trades.

As far as the currency factor, it doesn’t matter if you buy a Canadian etf or US etf, unless it’s hedged to the Canadian dollar then the currency risk is the same.

ie buying the ishares US market ETF is the same as buying the Vanguard US market ETF (VTI) except the Vanguard has a lower mer.
One problem with buying the Vanguard is that you have to make the currency conversion from Cdn$ so that might negate the lower mer depending of course on your situation.

Mike

8 Yves

From what I have seen currency neutral index funds usually have a .15% higher MER. However RBC’s US Index Fund is at 0.78% vs US Index Currency Neutral Fund at .69%. Can anyone explain why this would be? I will be moving some funds to one of these shortly can’t make a decision on which one to choose.

9 Four Pillars

Yves, I’ll have to look into your example since it doesn’t seem to make sense.

I have also read on the FWR forums that not all of the currency hedging costs are included in the MER and in fact might cost up to 1% per year.

Mike

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