Comparing the Costs of Index Funds and ETFs

The growing popularity of index investing has a lot to do with the increasing number of ETFs available, and that’s largely a good thing. ETFs generally have lower management expense ratios (MERs) than index mutual funds in Canada, so they are usually the best choice for large portfolios, especially if you make infrequent lump-sum contributions.

But ETFs carry additional costs that are often ignored by beginning investors. Trading commissions are the most obvious: it typically costs $10 to buy or sell ETFs, while index mutual funds can be traded for free. Some brokerages do offer a limited selection of commission-free ETFs, and a few independents offer trades for less than $10. But at the other end of the spectrum, bank brokerages may offer low commissions only on larger accounts: investors with less $50,000 may pay as much as $29 per trade.

Are index funds or ETFs right for you?

All of which is to say that as marvelous as ETFs are, they are often inferior to index mutual funds for investors with small accounts. My rough minimum for using ETFs is $50,000, but the actual cut-off varies a lot depending which specific ETFs or index funds you use, the commission charged by your brokerage, how many trades you make, and whether the brokerage charges an annual account fee.

To help you make this comparison yourself, I’ve built a spreadsheet you can download here. You can fill in the each of the yellow cells according to your individual circumstances and it will calculate the total annual cost of several different options. I have pre-programmed the spreadsheet with the three versions Global Couch Potato, as well as the ING Direct Streetwise Balanced Fund, which has the same asset allocation. You can customize it any way you like, but be careful not to mess up the formulas.

If you’re an investor who focuses only on MERs, you’ll be surprised at some of the results. For example:

• If you’re investing $50,000 in the Global Couch Potato and plan to make just six ETFs trades annually at $9.95, the TD e-Series funds are a much less expensive option. You wouldn’t save a cent with ETFs until you had more than $84,000.

• If you plan to make quarterly contributions—that’s 12 ETF trades—then even Option 3 of the Global Couch Potato (which uses RBC equity index funds) is cheaper for balances up to $30,000. This is why ETFs are often inappropriate if you’re building a balanced portfolio in a TFSA or RESP, since these accounts are unlikely to be larger than that.

• For small accounts, many brokerages charge an administration fee. If you assume a $50 to $100 annual fee, then the ING Direct Streetwise Balanced Fund becomes appealing for accounts under $20,000 or so, despite its 1.07% MER. In most cases it’s cheaper than the ETFs and the RBC index funds, and while it may be slightly more costly than the TD e-Series funds, it is far more convenient for new investors.

Download the spreadsheet and give it a try. Compare your own portfolio’s costs to the Global Couch Potato options, being sure to include all trading costs and account fees.

Book giveaway winner

Many thanks to the huge number of people who entered the draw for a copy of A Beginner’s Guide to Saving and Investing for Canadians. Congratulations to the winner, Linda, who has been notified by email. Stay tuned for more news about the book, including the e-book version we hope to have ready soon.