Index funds vs. ETFs

By Bruce Sellery on July 11, 2012
Estimated reading time: 5 minutes

Not sure whether to buy an index fund or an ETF? Bruce Sellery can help.

Question

I want to get into index funds but don’t know which ones to buy. Any advice?

Answer

So you want index funds and you don’t know what to buy. But I wonder if you actually want index funds or if you want exchange traded funds. Maybe you’re not sure. There are some very important differences between the two, so it pays to determine which will be best for you before you decide on specific investments.

At this point you’re either thinking, “Wow. He understands my question better than I do. Cool. I bet there is something here to learn.” Or you’re thinking, “Dude. I asked a simple question. Can you please give me a simple answer?”

If it’s the former, I’m going to outline some of the differences between the two products here. If it is the latter, I’ll answer that question in my next blog.

Similar but different

An index fund is a mutual fund that tracks the performance of a given index. For example, you could have an index fund that tracks the S&P 500, or the S&P/TSX 60. An Exchange Traded Fund (ETF) is a security that you buy and sell like a stock. You can find ETFs that track the very same indexes as an index fund. The two are similar, but different.

Cost: ETFs have a lower cost than index funds

The ongoing cost of owning an index fund or an ETF is reflected in something called the management expense ratio or MER. A typical Canadian index fund has an MER of about 1%, while the comparable ETF has an MER of about 0.2%. That might not seem like a lot, but it can make a big difference to your investment returns over time. For some investors in index funds, it is a price worth paying because it gives them access to financial advice, as well as other benefits I’ll explain in a moment, whereas with ETFs you’re on your own.

Index funds and ETFs are commonly used by passive investors. These products cost less than traditional mutual funds, which have MERs of about 2.4%. Mutual funds have higher MERs because they cost more to manage. The portfolio managers who run those funds are trying to beat the performance of an index by buying stocks they think will outperform. There is a lot of debate about passive versus active investing, but I’ll refrain from going into it here.

Commission: Index funds are easier to buy in small amounts

In additional to the ongoing costs of these products—the MER—it is also important to consider the cost of commissions. For example, if you have an automatic RRSP contribution going into your investment account each month, index funds make it easy to invest in small amounts on a no-load basis. That is, without paying a commission.

But investing small amounts into an ETF is a little trickier since you generally have to pay a trading commission each time you invest, regardless of the quantity you want. This could be as much as $20 per transaction and that makes the purchase of $100 worth of ETFs uneconomical. (There are exceptions. Some ETFs, like the iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (TSX:CDZ), allow you to make a pre-authorized cash contribution without paying commission, but not all brokers offer this feature, so verify that yours does before you buy it.)

There is also a hybrid version out there called the TD e-Series. These funds are effectively index funds, but with MERs that are competitive with ETFs. If you are going to make small monthly investments, index funds might make the most sense. However, if you are going to invest a large amount of money each time—say once a quarter—then the trading commission on an ETF becomes less of an issue.

Simplicity: Index funds have a few advantages

Index funds simply re-invest dividends as they are paid out. Most ETFs, on the other hand, put the dividends into your trading account and you then need to take the cash and invest it. Not as annoying as waiting for a rental car—which is incredibly annoying—but annoying all the same.

As well, index funds can be bought through a local bank branch or online bank. Exchange traded funds require you to open up an account at a discount or full service brokerage. That isn’t all that annoying either, but if the sums you’re investing are small, say under $10,000, you might not be bothered until you have more money to invest.

If you have more money to invest, and are interested in doing more complex trades, ETFs are a better option. You can buy and sell them during the trading day, and research more complicated niche products and strategies, like selling short. If you don’t know what I mean by “selling short” you definitely don’t want to do it.

A rule of thumb

My super simple and unscientific rule of thumb would be this: If you are investing under $10,000, use index funds. If you want to invest monthly, use index funds. But as you increase your assets move to ETFs because of the compelling advantage of cost.

P.S. It should go without saying that you need to develop a basic financial plan before you choose products. But I’ll reiterate the point here, and direct you to this great post on why plans should come before products.