Money saving tips for passive investors

There are two types of passive investments: index funds and ETFs. Understanding the difference can save you money.

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Every year, more and more assets get poured into exchange-traded funds. While it may be the most popular index-tracking investment on the market, it’s not the only one.

Index funds were created to give investors a way to mimic the performance of an index, such as the S&P/TSX Composite. The first one came to market in 1975. The first ETFs came along 18 years later. Index funds and ETFs are similar in the sense they both hold the securities in the index they track. But there’s one major difference: index funds trade like a mutual fund, while ETFs trade like a stock.

It’s a subtle distinction, but an important one. For Robb Engen, author of the Boomer & Echo blog, index funds allow him to save a ton of money on discount brokerage transaction fees. Every month the Calgary-based writer puts $100 into an RESP that holds four index funds.

By using index funds, Engen can avoid the trading fees he would have to pay if he bought ETFs that tracked the same index. On small accounts, most brokerage firms charge $29 per trade. If you trade frequently enough or have a large enough portfolio you can get that fee down below $10, depending on the financial institution.

Still, that’s a hefty fee to pay if you’re only buying or selling ETFs in small amounts. “I could pay $29 a shot for a $100 contribution,” he says. “ETFs make more sense when you have $50,000 saved up and maybe you rebalance your portfolio once a year.”

On the other hand, most brokerages usually allow their clients to trade index funds for free. There’s another reason some prefer index funds to ETFs: there’s less temptation to trade. Mark Hebner, president of Irvine, Calif.-based Index Funds Advisor and author of Index Funds: The 12-Step Recovery Program for Active Investors, says that many people buy and sell ETFs as if it’s a stock. As soon as the price falls they get out. Mutual funds are sold at the end of the day and the investor gets the closing price, which mitigates rash selling decisions.

“The ETF is a loaded gun that allows investors to shoot themselves in the foot,” says Hebner. “It’s sort of a sheep in wolves clothing, in a sense, because the investor thinks they’re a passive investor when they’re really being active.”

Several studies show that mutual fund investors lose out on long-term returns because they trade too early or too often. Hebner says that’s even more pronounced with ETF investors because of how easy it is to sell. “The average investor captures a very small percentage of the long-term index return because they’re encouraged to trade.”

If you are disciplined enough to hold on, though, ETFs can provide a better return, mostly because their fees are lower. Consider the TD Canadian Index e-series fund and the iShares S&P/TSX Capped Composite Index Fund. Both products are similar to each other, but the TD index fund has a management expense ratio of 0.33% while the iShares ETF has a fee of 0.25%. Performance is nearly the same. Looking at data over the past decade, these funds have a 99% correlation. So if when it comes to performance the difference in fees would be the main reason why ETFs may have higher returns than this index funds.

If someone wanted to own an ETF over an index fund they’d typically have to open a brokerage account, which is another reason why some people prefer index funds to the alternative. Vikash Jain, vice-president and portfolio manager at Oakville, Ont.-based Bellwether Investment Management, says there are still a large number of advisers who don’t sell ETFs, so the only way to get an index-hugging investment from a financial professional is to buy an index fund.

“Advisers need something to sell that’s passive,” he says. “They’re getting pushback from clients who’ve heard of these really cheap investments and they want a low fee option too.” Adviser purchased index funds are more expensive than ones bought through a discount brokerage, but they’re still cheaper than many regular mutual funds.

Engen does use ETFs in his RRSP and TFSA, but unless he gets a major influx of education-related cash, he’s sticking with index funds in his RESP. “It’s still super cheap,” he says, “and if you’ve only got $50 or $100 then it’s a good investment.”

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