Choosing ETFs: The folly of cutting fees at all costs

ETF management fees are now lower than ever. But there’s more to successful index investing than finding the cheapest funds

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From the Summer 2014 issue of the magazine.

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There’s a price war going on, and you’re the winner: Canadian ETFs have never been cheaper. An investor can now build a Couch Potato portfolio with an annual management fee of just 0.12%, less than half what it cost just a few years ago.

Keeping costs low is essential, and most Canadians are paying far too much: about $1 trillion is invested in mutual funds, many with absurdly high fees of 2.5% or more. But here’s the thing: once you’ve slashed your costs by 90% or more by using exchange-traded funds (ETFs) or index funds, whittling them down further won’t make much difference. Too many index investors are looking only at management fees and ignoring other factors. So before choosing the cheapest product on the shelf, consider the following.

Strategy is more important. Say you’re in the market for a new car. One option has better safety features, while the other has more horsepower. Do you simply go with the cheaper one? Of course not: you think long and hard about which feature is more important to you. The same should be true when choosing an ETF.
 

      Play: Dan Bortolotti talks MERs with 680 News’ Mike Eppel

 

The iShares High Quality Canadian Bond Index ETF (CAB) recently dropped its management fee to 0.12%. Its main competitors—the BMO Aggregate Bond Index ETF (ZAG) and the Vanguard Canadian Aggregate Bond Index ETF (VAB)—have management fees of 0.20%. But your choice shouldn’t be based solely on the difference in cost.

CAB tracks an index with 40% corporate bonds, while ZAG holds 30% corporates and VAB just 20%. Since corporate bonds are riskier than government bonds, these funds are not equivalent. Taking on more risk to save 0.08% in fees is like buying a car with fewer airbags because it’s cheaper.

Small fee differences are immaterial. ETF management fees are already very low, so trimming another 0.10% won’t have a material effect unless your portfolio is large.

Percentages can be misleading, so do the math to measure fee differences in dollar terms. One basis point (0.01%) works out to a dollar for every $10,000 invested. So if you have a $300,000 portfolio, reducing your overall costs by 10 basis points saves you $300 a year. On a $50,000 account, the annual fee savings is just $50, or less than a buck a week.

Saving even $50 would be worthwhile if it were assured. But an ETF with a slightly lower fee is not guaranteed to outperform.

Both iShares and BMO charge just 0.05% for ETFs that track the S&P/TSX Composite Index. Vanguard’s broad-market Canadian equity ETF tracks the similar FTSE Canada All Cap Index, with a slightly higher fee of 0.12%. But random events will cause one of these indexes to beat the other from year to year: over the last 10 years the index returns have differed by as much as 2.4 percentage points. This will have a much greater influence than the tiny cost difference.

Switching can be expensive. Investors frequently ask if they should replace their current holdings with one of the recently launched cheaper ETFs. I encourage them to remember transaction costs can easily overwhelm the difference in fees.

Say you hold $20,000 worth of a Canadian equity ETF and are thinking about switching to a competitor that’s 0.10% cheaper. That would save you $20 a year but likely cost $20 for the two trading commissions. The bid-ask spread on two trades might cost another $20, so you’re now looking at two full years before you break even on that switch.

The cost of switching is far higher if you’ll face capital gains taxes—almost all equity ETFs are sitting on gains now if purchased in the last five years or so. Suppose your Canadian equity ETF has a market value of $20,000, but you purchased the holding for $18,000. Selling could result in a tax bill of $250 to $450, instantly wiping out any benefit you’d get from a lower management fee over many years.

It’s all a big distraction. Perhaps the biggest problem with bargain hunting for ETFs is it distracts investors from what’s really important. I frequently hear from young people getting started or from experienced investors ready to switch to the Couch Potato strategy after growing disillusioned with actively managed mutual funds or stock picking. Their number-one concern is often whether to use this or that ETF.

My answer is always the same: don’t worry about that now. First make sure you’ve carefully determined the appropriate risk level for your portfolio. Then make sure you have broad global diversification. Set up a regular savings plan and contribute to your accounts regularly. Demonstrate you can be disciplined in sticking to your plan. Only after you’ve checked all those tasks off your list—and precious few investors can make that claim—should you sweat about a few basis points of management fees. Otherwise you’re fussing about a dripping faucet when your basement is knee-deep in floodwater.

For more index investing ideas, visit Dan Bortolotti’s Canadian Couch Potato blog.

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