Switching from mutual funds to ETFs

Three factors are driving this shift in investor behaviour. First, there is growing awareness that high costs embedded in mutual funds can severely limit their long-term returns. For example, consider a mutual fund with a typical 2% management expense ratio (MER), which earns an average compound annual return of 6% before costs. Investors selling their fund after 30 years would keep less than half the fund’s pre-fee total return with the rest consumed by fees. In contrast, investors in an index ETF with a typical 0.20% MER with the same 6% pre-fee return over 30 years would retain over 90% of the total return (you can run your own scenarios on the T-Rex Score calculator). Second, there are more ETFs from more sponsors than ever before and the list is growing. Third, the same big banks that dominate the mutual fund business have become the leading providers of ETFs and the online platforms that provide easy access to them.

Most index funds are ETFs, but many ETFs are not index funds

Many people are under the false impression that all ETFs are low-cost index trackers. Not so. But it is true that the largest and most liquid ETFs are index funds that  track the performance of a particular stock index, like the S&P 500, or a bond index such as the Bloomberg Barclays Canadian Bond Index. There are also “all-in-one” ETFs offered by a number of providers which package several index funds tracking diversified Canadian, U.S., and global stock and bond indexes. These convenient all-in-one ETFs come in graduated stock/bond combinations, including 80/20, 60/40, 40/60 and 20/80. 

These two classes of ETFs—single-index trackers and all-in-one ETFs—offer low cost, diversification, liquidity, choice of sponsor and convenience. There are also hundreds of higher-cost ETFs, including those focused on narrow bets like gold, cannabis or crypto, as well as “actively managed” diversified ETFs created by the big mutual fund providers in an effort to maintain their overall market share as growth of ETFs eclipses mutual funds.

ETFs: with or without advice?

If you plan to make the switch to ETFs, you must first decide whether you want to pay for ongoing advice and, if so, what type and frequency of advice you need. 

If your portfolio amounts to several hundred thousand dollars or more, you can find full-service advisors who will assess your circumstances, recommend an asset mix, provide additional ongoing advice and invest your funds in ETFs for an annual fee typically ranging from 1% to 1.5% over and above ETF MERs (there are some advisors who charge fees of less than 1% for those with portfolios of $1 million and higher). 

If your portfolio is more modest or if, regardless of portfolio size, you want automated investing with an asset allocation that matches your needs, there are a number of robo-advisors typically charging 0.25% to 0.50% annually on top of MERs of the mix of diversified ETFs they will manage on your behalf. 

If you have a good understanding of investment basics and have at least $25,000 or so to invest, you could efficiently create your own ETF portfolio through an online discount broker. Assuming you are a long-term, “buy and hold” style investor, your only significant cost will be the MERs of your ETFs. If you choose this route, or just want to check it out, try the “practice” trading accounts offered by many online brokers.

Investors who choose robo-advisors or online discount brokers but still want personal financial advice including retirement planning might consider a “fee-for-service” advisor. Fee-for-service advisors don’t sell financial products, so they are free from the conflict afflicting the majority of Canadian financial advisors whose compensation is based on the products they sell. Depending on the complexity of your circumstances and how frequently you need advice, supplementing do-it-yourself or robo investing with a fee-for-service advisor may be a very cost-effective choice.

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Choosing your new investment firm

Unless you want to switch from mutual funds to ETFs through your current advisor (assuming they provide access to ETFs) or if you have an existing online discount brokerage account, you must open investment accounts at a new firm. If choosing an online broker or robo-advisor, make sure to shop around and find the features and pricing that best fit your circumstances. Once you choose your provider, you will be guided through an online application process, which will include selecting the types of accounts you need and specifying the accounts at your old firm that you want transferred. Make sure to transfer registered accounts to a matching registered account at your new firm. In other words, transfer assets from your old RRSP into your new RRSP, from your old TFSA into your new TFSA, etc. This ensures the tax-advantaged status of your registered accounts is not disturbed.

There are two ways to transfer your assets to a new investment firm, both of which can take a week or two. Selecting a “cash” transfer will result in your old firm selling all your positions and delivering cash to your new accounts. Some robo-advisors require cash transfers as your funds will be invested immediately upon receipt in a diversified ETF portfolio.  Selecting an “in-kind” transfer means your existing mutual funds, stocks and bonds will be transferred into your new accounts as-is. Choosing an in-kind transfer will enable you to dispose of your mutual funds and any other unwanted positions coincident with your new ETF purchases, which mitigates the risk of missing potential market gains while your assets are sitting in cash. 

If you switch to ETFs in non-registered accounts, you will be subject to capital gains tax on any mutual funds you sell. The long-term fee savings from switching to low cost ETFs can often outweigh the tax impact (remember, you would eventually be liable for capital gains tax in any case). Also, your old firm might hit you with a parting gift in the form of transfer fees. Worse still, if your former advisor sold you Deferred Sales Charge or DSC mutual funds, you may incur a penalty for getting out. Once again, in my experience, long-term fee savings usually exceed the one-time penalties arising from this particularly egregious form of mutual funds.

Build your ETF portfolio

If you choose a traditional advisor or a robo-advisor, a portfolio will be recommended to you. If you choose to do it yourself through an online discount broker, take these steps:

• Determine your overall portfolio asset allocation—in other words, the proportion of stocks versus fixed income (bonds/GICs). Asset allocation is a balancing act between the opportunity to earn a good return and the risk that goes with it. Consider your investment objectives, time frame and comfort level with the roller coaster ride that comes with owning stocks. This will be your most important investment decision.
• Choose among Canadian, U.S. and global markets. Given the small size and breadth of the Canadian stock market, constructing a diversified portfolio requires inclusion of ETFs holding non-Canadian stocks (all-in-one ETFs do this for you).
• Choose the types of ETFs that best suit your needs: index, all-in-one or active.
• Select your ETFs. The CETFA website provides lists of top ETFs, and all major providers have websites providing full details.
• Adjust your portfolio when, as a result of changing markets, your asset allocation drifts significantly away from your desired ratio (all-in-one ETFs do this for you).
• Adjust your asset allocation over time as your circumstances change.

Whether or not you decide to pay for ongoing advice, if you are considering ditching your high-cost mutual funds, a simple, diversified, low cost portfolio can be built with three to four ETFs, or even just a single all-in-one ETF. And remember, before you make the switch, taking some time to brush up on investment basics will help you make better-informed decisions. As Warren Buffett declared: “The best investment you can make is in yourself.”

Larry Bates is the author of Beat the Bank: The Canadian Guide to Simply Successful Investing and is an investment advisor with Aligned Capital Partners Inc.

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