This is the last of three posts on investing with passive mutual funds and ETFs. In the first post, we reviewed the broad underperformance of active mutual funds, the migration of retail investors to passive funds, and why I recommend passive funds in general. The second post discussed the different share classes of mutual funds and compared the relative advantages of passive mutual funds and ETFs. In this last post, we review how investors can best use the different types of passive funds offered in the retail market.
ETFs often offer the best options for passive investing, but not always. Of course, mutual fund fees are higher, and paying more for the same portfolio is annoying. These differences in costs are substantial. Take the RBC Canadian Equity Index ETF Fund, for example, which is available in several mutual fund share classes and is 100% invested in the iShares Core S&P/TSX Capped Composite Index ETF:
Table 1 – RBC Canadian Equity Index ETF Fund Fees
| Type of share class | Management Expense Ratio (MER) |
|---|---|
| Mutual fund series A (commission-based) | 1.26% |
| Mutual fund series D (DIY) | 0.42% |
| Mutual fund series F (advice-based) | 0.16% |
| Mutual fund series O (institutional) | Negotiable management fee + 0.02% administration fee + applicable taxes |
| ETF | 0.06% |
Source: RBC
As Table 1 illustrates, the fee difference between a passive mutual fund and its equivalent ETF can exceed one percent, so investors must ensure they get value for their money. Here are a few things to consider when seeking the most appropriate option among the ETFs and mutual fund share classes on the market.
Investment geeks are passionate about investments, spend a fair amount of time reading and learning about them, and enjoy managing their portfolios. ETFs and DIY mutual fund shares are usually their best options.
Other people realize they need to save and invest for the future but have little interest, time, or mental space to dedicate to portfolio management. Passive ETFs and fee-based mutual fund shares will be their best bet for simplifying their portfolio management with the help of an advisor.
Fees are less critical for small portfolios because even a sizable difference in the MER percentage does not represent a large sum. For an investor with $2,000 to invest, a difference of 1% in MER represents $20 per annum. This same difference on a $200,000 portfolio represents $2,000 per annum. The larger the portfolio, the greater the benefits of low-cost products like ETFs.
Automated contributions are probably one of the best ways to save, invest, and build wealth. This is far more effective than waiting for the so-called “RRSP season” to contribute to your portfolio. With automated contributions, you eliminate the temptation to spend the share of your income earmarked for investing. Contributions can often be made weekly, bi-weekly, monthly, quarterly, or annually. The more frequent the contributions, the faster wealth compounds. Not only will you save as soon as income is earned, but your savings will be put to work immediately.
Beginning investors with a regular income should start by contributing systematically to DIY or fee-based share classes of passive mutual funds. Another convenient and low-cost solution is to invest with iShares passive asset allocation ETFs, a rare ETF series that allows automatic contributions. When the portfolio reaches a certain size, the investor can transfer the bulk of their assets into cheaper ETFs to reduce investment costs while keeping some of the original investments to pursue systematic contributions.
Even if you start with small amounts, automated contributions may help you develop an investor mindset. If you get to the point where you enjoy the process of effortlessly building wealth, you will likely increase your contributions and take the road to financial freedom.
Retirees and pre-retirees are often obsessed with high-dividend stocks to generate income. However, companies pay dividends by withdrawing from their bank accounts. That’s why, right after a dividend is recorded, the company’s stock price drops on average by the amount of the dividend per share. A company that pays a high dividend has less money to reinvest into its operations, resulting in less potential for earnings-per-share growth and share appreciation.
Dividends are not free money, and for investors, they are often a less tax-efficient way to generate cash than selling fund shares, especially for a high-income earner holding investments in a taxable account. In most cases, taxable investors should aim to receive portfolio income as capital gains rather than dividends.
Mutual fund automated withdrawals offer a simple solution to generate tax-efficient cash distributions. For every dollar received, a substantial portion will likely be a tax-free return of capital and tax-advantaged capital gains. That’s why investors should consider mutual fund share classes.[1]
If you want to invest with professional help, I recommend doing business with an independent fee-based advisory firm or a robo-advisor. The firm will ideally build a portfolio of passive fee-based mutual fund shares and/or ETFs. To me, commission-based mutual fund shares are a choice of last resort for several reasons.
First, passive commission-based mutual fund shares generally pay a low trailer commission to the advisor; thus, you can expect pressure to invest with more expensive actively managed funds. Second, the service level associated with commission-based share classes is generally basic; you will likely be disappointed if you’re looking for extensive financial planning.
If you elect for passive commission-based mutual fund shares, do your homework first: fees may vary widely across similar funds. For example, the RBC Canadian Equity Index ETF Fund’s commission-based share class comes with a 1.26% management expense ratio (MER). The TD Canadian Index Fund equivalent share class charges only 0.66% for a similar portfolio. Remember that each share class has a unique Fundserv code, and that you need to know in advance which products you’re interested in. If you walk into a branch of your bank and ask for passive funds, the person behind the desk may not offer you the cheapest product and may not offer passive funds at all.
Investors have more options than just mutual funds and ETFs. Your willingness to handle portfolio management yourself or delegate it, the size of your portfolio, the benefits of automated contributions and the need for tax-efficient income should indicate the type of passive ETF or mutual fund share class most appropriate for you while accounting for the context of your unique needs, circumstances, and preferences.
[1] Several income-oriented ETFs offer monthly distributions; however, these instruments do not provide investors with control over the asset allocation, income level, and frequency of distributions.
