Why index mutual funds still have a place

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. Investors who never considered the RBC Canadian Index were suddenly drawn to the iShares Canadian Fundamental (CRQ), even though both have an identical MER of 0.72%.

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, 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.