Sometimes figuring out the right thing to do is not as simple as a straight forward action. There will always be twists and turns, errors that have to be corrected and maybe some paths will have to be retraced. Learning through failure is the quickest way to correct your mistake. I’ve made many mistakes, which is why I can write about them to you and you can avoid those same pitfalls. When deciding whether to use mutual funds or ETFs, it’s really not as simple as choosing the fund with the lower management expense ratio. It may seem logical to choose ETFs because you want to have the lowest cost possible, but once you factor in your investment strategy it might not make sense to use ETFs as your investment vehicle.
ETFs and mutual funds share very common characteristics as an investment vehicle because they both offer asset diversification, follow indexes and provides the ease of purchase through a self directed brokerage account. When you do your research into the management fees of both investment options, no doubt the ETFs will look much more attractive because they are more passively managed, but that doesn’t mean that the ETF is the best product for you. If you have read my post on Dollar Cost Averaging and you are considering the option of investing on a monthly basis, then in some instances, mutual funds are a better option.
How does that make sense? Isn’t having a lower MER better?
In the long run, a lower MER will always be the better option, because you will realize a greater portion of your portfolio’s gains. However, if you are just starting to build your portfolio then the trading costs of ETFs could make it cost prohibitive to invest in them. Let’s take a look at a hypothetical example below:
- You invest $100 per month buying an ETF or mutual fund with 0.009% MER or 0.33% MER respectively (These are real MERs based on Canadian Index funds)
- Assume that the price of a single share neither rises nor falls to make the math easier
- The price of each share is fixed at $10/share
- The cost of ownership is calculated using the MER multiplied by the total value at the end of the year plus the sum of the cost per trade for each month
- Commission on each ETF trade made is $5.00 per transaction
The chart illustrates how frequent purchases of ETF shares can result in a large fee for just trading the shares. Even at a discount brokerage such as Questrade that offer $5 per trade, the cost of the trades can add up to be considerably greater than the higher MER of the mutual fund. This makes ETFs a bad choice for investors who want to make small monthly contributions to their investment portfolio. High MERs are not the only thing that will decrease potential returns of your portfolio. High trading fees will also take a bite out of your principle. In the example above, the cost of the trade would be 5% of the monthly contribution which is a huge gap to overcome considering you would need the share to rise 5.3% just to overcome that deficit. If you wanted to break even on the trading costs in the above example, you would have to make a monthly contribution of $2 230 or buy 223 shares a month just to have the ETF cost lower than the mutual fund. Seriously, who has $2 230 to invest every month?
If you are just starting out and making small contributions to take advantage of dollar cost averaging, don’t get caught up in the hype of ETFs. They get marketed by the brokerage firms because they offer lower MERs, but what the brokerages won’t be telling you is that they are taking a huge commission fee on every trade you make. Once you build up your investment portfolio, then it makes much more sense to start looking at ETFs. That’s when the annual costs that get deducted from your principle matters much more.
Some may read this and point out that some financial brokerages are now starting to offer no commission ETFs. This is true, but the ETFs that are offered are often just a select few and could also be ETFs that you just don’t want to invest in. Just make sure you are comparing apples to apples and not apples to oranges because quite often the mutual fund you may want to buy may not have an equivalent ETF that has no commission fees on the trade. If your brokerage firm offers no commission trades for ETFs, then explore the option, because the playing field evens out and at that point the lowest MER will end up coming out on top.