The ETF: Building a Better Fund?

An Introduction to Investment Planning – Part 5.6

Is the ETF a Better Fund?

Tax Efficiency

Due to the differences in the way mutual funds and ETFs are created and redeemed, there tends to be bit more tax efficiency in the case of ETFs. Therefore, if you have a non-registered or taxable account, it may be to your benefit to own ETFs. If, however, all your investments are held in registered accounts, this is not a significant factor.

 

Lower MER

Generally speaking, ETFs have lower expenses so it can be to your advantage to invest in ETFs, especially if your accounts are of a substantial size. A $10,000 investment in an ETF with a 0.25% MER will cost you $25 in the course of that year, whereas the same investment in a mutual fund that has a 2 % MER will cost you $200. Having said that, some ETFs charge close to 1% while there are mutual funds that charge an MER of under 0.5%.

 

Commissions

As mentioned above, buying ETFs on an exchange usually requires the payment of a commission. If you are systematically buying smaller amounts, a commission charge can be quite expensive, negating the advantage from a lower MER. The following chart provides an illustration:

Scenario 1	Amount	MER	Commission	Total Cost
Mutual Fund	$100	2.00%	$0.00	$2.00
ETF	$100	0.25%	$10.00	$10.25
Scenario 2	Amount	MER	Commission	Total Cost
Mutual Fund	$10,000	2.00%	$0.00	$200.00
ETF	$10,000	0.25%	$10.00	$35.00

You can see that small purchases may make more sense in the case of a mutual fund but larger purchases tend to favour the purchase of ETFs.

 

Systematic Investing Not Possible

Mutual fund companies facilitate the set up of Systematic Investment Plans in which you set up a pre-authorized amount to be automatically transferred from your bank account into your investment account, whereupon that amount, to the penny, will be invested in a mutual fund of your choice. For ETFs, which are traded on an exchange, it is simply not possible to automate such purchases.

 

Calculating the Purchase of an ETF is not simple

Mutual funds are frequently bought in dollar amounts. If your investment account is self-directed, all you need to do is deposit the amount you wish to purchase into your account and enter an order to buy the mutual fund in the exact dollars and cents you wish to spend and the purchase is made. It does not matter when you put that order in because the mutual fund purchasing system will still only spend the dollar amount you specify.

 

For ETFs, you deposit your dollar amount, subtract the commission, divide the ask price of the ETF into the net dollars remaining in order to determine the number of units you can buy, place your order, and then decide what to do with the cash balance remaining. Here’s a table illustrating the difference using a situation where the current ask price of the ETF is $26.86:

Steps	Deposit	Less Commission	Net Amount	Ask Price	Units Bought	Amount Left Over
Mutual Fund	$10,000	$0.00	$10,000	N/A	N/A	$0.00
ETF	$10,000	$10.00	$9,990	$26.86	371	$24.94

While it’s not quite true that the number of units you bought is irrelevant, you don’t have to concern yourself with the number of units when you make the purchase. Note that every penny of your mutual fund is used up whereas in the case of the purchase of an ETF, you have $24.94 left over.

 

Temptation to Trade Frequently

While trading ETFs on an exchange requires a bit of a learning curve, it is not that difficult once you are used to the process. Mutual funds may be easier to buy, but usually, mutual funds charge penalties for early redemptions. ETFs have no such restriction, which can lead people with a speculative bent – or a gambling addiction! – to trade into and out of ETFs frequently, perhaps even multiple times daily. Although it is not unheard of to make a profit in this manner, the frictional costs of commissions charged, not to mention the time it takes out of your day to be an active trader, usually is not worth the effort.

 

Simplicity of Choices … Going, Going, Gone

One of the knocks against mutual funds is that there are just too many choices out there. That simplicity of choice remained with ETFs in the early days. Most ETFs simply sought to passively track a particular index, such as the S&P/TSX Composite index in Canada, the S&P 500 index in the US, or the MSCI EAFE index for international stocks. However, as the major players in the ETF market captured the majority of that segment and set MERs increasingly lower, new ETF issuers had to come up with different strategies or rules to follow so as to compete in a different part of the investing marketplace. We now have as wide a variety of ETFs as we have mutual funds. What to do?

 

I will address investment choice in future posts. Coming up next, however, will be a post on three items to attend to in the new year.

 

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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.