Hidden Costs In ETFs You Should Know

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Much has been made about the high fees that are associated with investing using mutual funds. Investors are now getting very savvy about minimizing their exposure to high fees that ultimately eat into their gains over a long period of time. We’ve all read stories and articles about how much money you could be throwing away by investing using mutual funds that carry 2.5% MERs.

This has led many to believe that buying ETFs (exchange traded funds) are the best way to invest in equities. While it remains true that ETFs represent very good low cost alternatives to investing in the stock market, not all ETFs are created equal. It shouldn’t be generalized that buying ETF is a good way to invest because even some ETFs can carry high costs.

Commission Fees

I have already written before about how advice from financial advisors are not actually free. There’s never free advice when it comes to financial advice, maybe except if you’re reading this blog. Mutual funds have expensive fees where advisors get their cut from. The greater portfolio they manage, the more money they make. The are essentially salespeople, trying to get as much of the pie as possible.

For those who are interested in self investing, ETFs are the type of funds that everyone starts looking towards. Despite the lower cost of owning ETFs, they do have one thing that is different. The cost to buy them.

Depending on the brokerage that you may be using to trade ETFs, commission fees can bite into a large chunk of your investment. Unlike, mutual funds, there are trading costs associated with buying or selling ETFs. For small amounts or monthly contributions, buying ETFs with commissions might not be the most prudent method of investing. If you also need to sell to rebalance your portfolio, the costs of such transactions could make it prohibitive to use ETFs. Commission fees can range from $5 – $25 per trade depending on volume, amount invested an the brokerage you are using.

Before making any trades with your brokerage, make sure you know how much the commission fee will be and how much it will be taking away from your investment. Anything greater than 1% of your investment is already too much.

Capital Gains

money_pileI’m a believer of the buy and hold forever strategy of investing. Sticking to a simplified balanced portfolio that is re-balanced on an annual basis is an easy strategy to follow. However, even if you never sell the ETFs that you buy, that doesn’t mean that you won’t get hit with capital gains.

ETFs are managed by a fund manager no different than a mutual fund. In general, ETFs that track an index will have very little trading activity, but there are instances where a fund manager will buy and sell different stocks.

Even within index funds, there are different ways in which the fund may track the stocks that make up the index. Some ETFs may weigh stocks based on market capitalization value. Others may weigh their index using an equal balance across the board. Depending on how the structure of the ETF may be be setup, the fund manager may end up buying and selling shares to keep the ETF balanced.

These transactions will ultimately trigger capital gains that end up being taxed at year end. By law, any capital gains must be distributed before the end of the year for any funds. This means you could receive capital gains on funds where you never sell a unit.

It’s important to know how the structure of the ETF works so that taxes don’t cut into your compound gains.

Withholding Taxes

If you live in Canada, you should already be aware that dividends paid by Canadian corporations are given a dividend tax credit that helps you save on taxes. The same can’t be said for dividends that are received from foreign owned corporations. American companies that are owned in ETFs are subject to a 15% withholding tax by the American government. This means that if your dividend pays 2% a year, the US government will hold back 0.3% in taxes. It might not seem like a lot, but remember every little bit in the long run counts.

The one good thing about the partnership between US and Canada is that you can claim this tax credit back, but only if you invested in a non-registered plan. If you invested in US ETFs in your RRSP then other rules apply.

If your US equities are held in an RRSP account, the only way you can avoid withholding taxes is to buy the equities on the US stock exchange. The downside to this is that you have to convert your Canadian dollars to US dollars to buy, but you won’t have to pay any withholding taxes as the agreement between the two governments makes this exempt. If you buy your US equities through the Canadian stock exchange and use an ETF that holds US stocks, then you’re out of luck. The withholding taxes apply and you cannot claim it back.

If you buy any US equities in your TFSA, the withholding tax always applies on dividends, and there is no way to claim it back.

This can get confusing, but it is something to be aware. You might see small differences in the returns of ETFs that are very similar only because of the drawback of withholding taxes. Therefore as a simple word of advice, if you want to nickel and dime your way to saving as much as possible on fees and taxes then invest using US dollar in your RRSP. There is nothing wrong with hold US dollars, plus think of the vacations you can have in the future with US dollars.

Never Expect Free

There’s never a free lunch. And that applies to ETFs as well. Despite the fees and taxes of owning an index ETF, they are still by far the most efficient way to own most of the stock market. ETFs still provides more diversity than buying single stocks and lowers the risk of investing in the stock market.

As your own personal investment portfolio continues to grow, learn more about ETFs and how it can make your investments much more efficient than owning mutual funds. If you’re starting out and have little capital, mutual funds are probably still the smarter way to grow, but if you have a brokerage that allows commission free trading then give ETFs a look.

 

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