Brew your own low-cost custom index

Computers are everywhere these days, but they were a novelty when I was growing up. They weren’t that useful and you had to program them manually to do much of anything.

Today, they’re far more capable and much less expensive. But they aren’t the only thing that’s improved over time. The humble brokerage account has evolved significantly thanks, in no small part, to those fancy adding machines.

In the past you had to call up your broker to place a trade, spending hundreds of dollars in commissions. Now you can trade shares with a click of a mouse while sipping your morning coffee for only a few dollars per trade. The advent of easy low-cost trading opens up new possibilities for self-directed investors.

Fee reductions are a boon to long-term investors. Happy couch potatoes can buy a plethora of exchange-traded funds (ETFs) for surprisingly little. But thrifty long-term investors might consider bypassing some higher-cost ETFs infesting the Canadian market and buy the stocks they hold directly.

I’m not talking about all ETFs. Some great options let investors buy large bundles of stocks inexpensively. For instance, Vanguard’s Total Stock Market ETF (NYSE:VTI), costs only 0.06% a year and tracks a representative collection of more than 3,000 U.S. stocks.

The situation in Canada is a bit different. Our stock market is much smaller, with only a few hundred stocks of any real size, while our ETFs are relatively expensive. Investors can replicate some of our ETFs and, with apologies to Canadian Tire, save like Scrooge.

Consider the popular BMO S&P/TSX Equal Weight Banks Index ETF (TSX:ZEB), which charges 0.62% per year. It follows a grand total of six big bank stocks, so it best serves active traders who want to move in and out of the banks many times a year.

On the other hand, the fee math doesn’t work for long-term investors with $30,000 to invest in it. They face an annual fee of about $186, but at $10 per trade it would cost only $60 to buy all six stocks individually. With reinvested dividends and some small adjustments, the annual fee comes to $60 per year, so they’d save about $126 a year going direct. Some discount brokerages offer free dividend reinvestment plans, cutting costs even more.

It’s one thing to like bank stocks, but quite another to give them your hard-earned dollars needlessly. (Full disclosure: I own some BMO shares personally so my craven self-interest urges you to ignore the foregoing and buy more of their products.)

BMO is hardly alone in creating such funds. BlackRock is the leader in overly-focused Canadian sector funds. Its popular iShares S&P/TSX Capped REIT ETF (TSX:XRE) owns 15 Canadian real estate investment trusts (REITs) and charges 0.6% per year. Unlike BMO’s version, it doesn’t buy equal amounts of each trust. It buys more of the largest REITs, by market capitalization, and fewer small ones. Thus, more than 30% of its portfolio is concentrated in only two REITs, with the top ten holdings making up over 82%.

Putting $50,000 or more into this trust isn’t out of the question but at $50,000 the annual fee amounts to $300—rather high compared to $150 for the 15 commissions needed to replicate it. Thrifty investors can save more by buying a similar portfolio that contains only its top 10 holdings. (Mind you, they won’t track the index as well so they may do better or worse than the index over time.) True buy-and-hold investors should consider saving their shekels and avoid high-cost, concentrated ETFs.

This approach isn’t for everyone. Some may not want to spend the small amount of time and effort required to set up such portfolios. But many investors are retired and happy to hunt for bargains. It takes little effort to save a few hundred dollars a year.

Truly dedicated stock shoppers may think about using a similar approach to tackle the larger Canadian stock indexes. The argument for moving up to the S&P/TSX 60 isn’t as compelling because the annual cost of the better ETFs tracking it is comparably low while the commission cost on a 60-stock portfolio is higher.

It all depends on commissions and fees. With some brokerages charging under $5 per trade, replicating larger portfolios becomes a real possibility for buy-and-hold investors.

It’s much easier to go to stocks when you’re willing to follow a non-index-like portfolio. It’s a snap to buy the largest 10 or 20 stocks on the TSX and stick with them. Personally, I might be inclined to start with the cheapest stocks in the S&P/TSX 60 based on their price-to-earnings ratios or opt for those with the highest dividend yields. Think of it as brewing your own low-cost custom index.

However you go, be glad discount brokerages keep improving. Hopefully they’ll lower prices further and provide still better service. M

Norm Rothery, CFA, PhD, is the founder of StingyInvestor.com