The weekend edition of the Globe and Mail carried a column by Noreen Rasbach, who is pondering a switch from mutual funds to ETFs, but is worried about the extra costs for small investors:
One of the downsides of ETFs is that they are bought and sold on exchanges, so you have to pay commissions, and it’s tough and expensive to do for people who set aside small amounts to invest each month.
While I am a huge fan of Exchange-Traded Funds (ETFs), it should be remembered that they are merely a tool to achieve an objective: to track broad stock market indexes at the lowest possible total cost. That objective can also be achieved by investing in index mutual funds. ETFs have lower MERs but investors pay a trading commission for each transaction. Index mutual funds, on the other hand, can be purchased in small amounts, typically without any fees but the MER is higher. A further advantage of mutual funds is that any distributions can be reinvested without any charge.
An investor just starting out can build a fairly diversified portfolio using just a few index mutual funds and can switch to an equivalent ETF after accumulating sufficient funds. One thumb rule that could be used to guide when to make the switch is to require the MER differential to pay for the trading commission within one year.
For instance, the TD e-Series Canadian Index Fund (TDB900) has a MER of 0.31% and the iShares CDN Composite Index Fund (XIC) has a MER of 0.25%. An investor paying $10 for each trade could make a switch after accumulating $16,700 in TDB900. Note that the switch can be made sooner if the MER differential is larger. The TD e-Series US Index Fund has a MER of 0.33% but the cheapest equivalent ETF costs just 0.09%, which would imply that the swap could be made with $4,200 (ignoring the cost of currency conversion).
Investors should also pay attention to the tax consequences of a swap: taxable accounts may take a capital gains hit when an index fund is sold to buy an ETF.