Switching from mutual funds to ETFs
Thinking about switching from high-fee mutual funds to low-fee exchange-traded funds? An investor advocate walks through the steps—and watch-outs—to follow when you're ready.
Thinking about switching from high-fee mutual funds to low-fee exchange-traded funds? An investor advocate walks through the steps—and watch-outs—to follow when you're ready.
Photo by Daniel Bosse on Unsplash
Are you considering switching from mutual funds to Exchange Traded Funds (ETFs)? If so, you are not alone. Growing numbers of Canadians are making the move. This is evidenced by 2020 fund statistics published by The Investment Fund Institute of Canada, which show net redemptions of mutual funds during September, while net purchases of ETFs were $669 million for the month and $32 billion year-to-date.
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.
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.
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.
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.
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:
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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This article is very well-timed since I am currently reading the Larry Bates book, “Beat the Bank”. I also recently listened to Mr. Bates during a webinar presented by our Regina Public Library during their financial literacy month.
I discovered that I have been paying through the nose for some of the mutual funds that I have been contributing to for years. It is really troubling that the Canadian banks are allowed to charge some of the highest fees in the world for their mutual funds. Extremely unfair, especially when a lot of people don’t have adequate pension income from their life savings!!
It is not true that you have to switch investment accounts to a new firm rather than staying with your existing online discount brokerage if you wish to have some of your investments as ETFs.
I believe this is a major error in your article.
Within a TD direct discount brokerage account anyone can hold individual stocks, ETFs, and mutual funds simultaneously.
Please let your readers know that they do not need to go to all the bother of changing discount brokerages to simply buy ETFs.
I have also started reading Larry Bates book and have started researching moving my Mutual Fund RRSP to an online discount brokerage where I already have a TFSA. How can the “in kind” move work though ? My online discount brokerage does not sell Mutual Funds (I think), so won’t I have to dispose of the mutual funds with my current provider and move it as cash ?
Also, how does one decide if it is the right time to sell the mutual funds. From July to Nov end of 2020, I see the unit values have increased and my overall return is 5%, so is that a good indication to sell the mutual funds ? Only one fund, which is a bond one has slightly gone down in value, but rest of them are up. I cannot even get a clear statement of fees I have paid them and called them only to have a 3 business day turn around for an advisor to call me. My statement or transaction history does not list the monthly fees. I just know the MER for each fund, but that does not show the real impact of fees until I see it in dollars. They hide it well.