Tag: index fund

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.

As a low cost investor I like researching different low cost options and trying to decide which is best for my situation. One question that comes up frequently from investors with small portfolios is whether they should buy low cost index fund such as the TD e-series or by ETFs which have lower mers than the index funds but you have to pay a minimum of $4.95 per trade. Other blogs have covered this topic and based their answer mainly on the portfolio size. If your portfolio is significantly less than $25k then start an account at TD and around $25k mark, transfer it to a discount broker like Questrade and buy ETFs. This is definitely the cheapest strategy but it involves setting up two accounts and doing one transfer.

One problem with that method is that I suspect a lot of investors will set up the account at TD but they won’t switch to a discount brokerage at the right time or at all which means in the long run they will end up paying more fees compared to if they had just started buying ETFs even when the account was fairly small.

To avoid this problem I would suggest that another strategy to consider is to pay the higher costs of a discount brokerage right from the beginning because it won’t be long before you will be saving money and can recoup the extra expenses from earlier on. What I did was to set up a model which will tell me if an investor has a small portfolio then how much money per month do they need contribute to make this strategy worthwhile. There is a link to my spreadsheet at the bottom of the post.

Another part of this idea is to start with Questrade because it’s the cheapest discount brokerage available but alter your trading habits – if you contribute monthly then only buy one ETF per month. Another great idea is to only buy an ETF every second or third month, especially in the beginning.

What we are really looking at is the idea of doing either TD or Questrade and seeing how long it takes for the break even point to occur. If the point is fairly soon (ie less than 5 years) then it might be an idea to just go with the ETFs if you don’t think you will make the switch from TD to Questrade down the road.

This chart indicates the final numbers. The second row has the portfolio size, the second column has the monthly contributions and the other numbers are the number of years until the break even point. Keep in mind that the break even point is when all the losses in the early years are made up for.

For example if you have a starting portfolio of $10k and you contribute $250 per month then after eight years the total costs of ETFs (for all eight years) is the same as the cost of index funds.

		Portfolio size
		$0.00	$10,000	$20,000
Contribution	$100	30	13	4
	$250	13	8	3
	$500	8	5	2
	$750	6	3	1
	$1000	4	3	1

 

As you can see, the monthly contribution is a big factor in this decision – if you are contributing larger amounts then even if you start with nothing, the Questrade option is better. Another factor of course is the starting portfolio size – if you already have $20k then it’s probably better to start at Questrade . The reverse of course is true – if you are contributing $100 per month then you are probably better off with TD unless you have close to $25k.

This is definitely a personal decision but I would think that unless you are super keen to save every cost possible then consider doing Questrade from the beginning if the break even point is less than about 5-7 years.
Keep in mind as well that a lot of the initial trading costs can be saved by contributing to the Questrade account monthly but only buy ETFs infrequently.

I’m also using a very simplified portfolio that is equally weighted among the securities. If you want more securities that are not equally balanced then that may add to the trading costs with the Questrade option. Even there if you want a small emerging market exposure you can just make one purchase a year for example in that class. You might not have your desired asset allocation at all times, but if you portfolio is very small then that probably doesn’t matter that much.

This analysis assumes that you value low costs above convenience – one big advantage of an index fund is that you can set it up to take the money from your account and make the index fund purchases automatically. This can’t be done with ETFs so you have to login every month and make a purchase.

Conclusion

If you are a big contributor with a small portfolio and are keen (but not superkeen) to save costs then it might make sense to start at a discount brokerage instead of at TD and then switching.

I suspect for a lot of investors however it might make sense to just go with TD and only switch over when they have a significantly large amount say over $50k. Another plan might be to accumulate $50k or $100k at TD and then transfer to Questrade if they will pay for the transfer costs. Meanwhile you keep accumulating at TD.  The choice between index funds vs ETFs is not an easy one.

This is the spreadsheet I used.

More information

Should I Buy ETFs Or Index Funds?