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How Mutual Funds Work: Exchange Traded Funds
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How Mutual Funds Work: Exchange Traded Funds

Contributed by: martingale

Mutual Funds This article will explain what an Exchange Traded Fund is, how to use them to manage your own RRSP, and what choices are available. We'll also have a look at the way mutual fund companies get paid so that you can avoid paying too much.

Canadian mutual funds are in general a lot more expensive than American funds, and there aren't a lot of different asset classes to choose from. Fortunately there are two points of light: First, American Exchange Traded Funds (ETFs) can be purchased by Canadian investors as foreign content; second, we have a few ETFs of our own here in Canada. Given the absence of good conventional funds in Canada, I highly recommend that you build your portfolio primarily from these ETFs. But beware of trading fees! In this article I will review what an ETF is, take a close look at the fees, compare ETFs and conventional funds, suggest some strategies, and provide you with a list of ETFs you should consider so as to construct an efficient portfolio.



What Is an Exchange Traded Mutual Fund

The basic idea of any mutual fund is to pool money from a large number of investors so that a large number of securities can be purchased efficiently. Each investor therefore gains the advantage of being well diversified, without the time and expense of having to purchase the individual securities. Exchange traded mutual funds are just another variation on this theme--except that they trade on a stock market like an ordinary stock.

There are a few key differences between an ETF and a traditional "open-ended" mutual fund that you would buy directly from a fund vendor:

  • You will need a "self-directed" trading account with a discount stock broker
  • You have to pay trading fees and spreads to buy an ETF, just like you do when you buy a regular stock, but you won't pay any other "loads".
  • Whereas investors can redeem units of a traditional mutual fund an ETF generally does not permit redemptions. Instead you sell your units on the market like you would sell any other stock.

I will cover each of these issues in turn, then take a look at the ETFs available to Canadian RRSP investors.

Choose a Discount Broker

Acquiring the appropriate trading account is a small administrative matter, and I recommend you set about doing that anyway, even if you decide not to invest in ETFs. A brokerage account will also enable you to buy mutual funds, and to manage your fund holdings online through a website, generally at lower cost than doing the same by telephone. You lose nothing by setting one of these up, so do it.

As at December 2004 I will even go so far as to recommend a few discount brokerages. Your choice is essentially between TD-Waterhouse, which offers more services through its discount brokerage at not unreasonable prices, or between Credential Direct (associated with Credit Unions) which has slightly cheaper fees but lacks many of the services provided by TD-Waterhouse. In particular, TD-Waterhouse charges a higher brokerage fee ($29) for trading stocks, and a lower fee for trading traditional mutual funds (if you trade TD's, which are OK). Credential Direct, on the other hand, charges only $25 to trade stocks, but always charges a fee if you trade traditional mutual funds, and their web interface is not as nice. There are also some other services offered by TD that are not available through Credential, but if you just want to invest in ETFs these may not matter to you.

Yes, compared to the United States where you can trade stocks for less than $10 these fees are obscene. Write your Member of Parliament and complain: we are being ripped off.

How Do Mutual Fund Companies Get Paid?

Whenever you interact with the financial service industry you pay an array of upfront fees and an array of hidden fees. Their goal is to maximize the fees you pay. Your goal, obviously, is to minimize fees.

With a traditional mutual fund there are four kinds of fees that you pay:

  1. The person who sold you the fund may charge you some service charge.
  2. The fund itself may charge you a "load", either when you buy into the fund ("front-end") or when you sell your units ("back-end").
  3. The fund will charge every unit holder a "management expense ratio", which the fund manager will deduct from the fund annually. This expense ratio is widely reported in the fund's prospectus and in newspapers as the "MER" .
  4. The fund will incur trading costs and other expenses in the course of its operation--such as brokerage fees--which are not considered to be part of the MER. It is generally nearly impossible to get a clear accounting of these trading fees, something that should worry you if the fund is paying these fees to a related organization, such as the brokerage arm of the same banking group that runs the fund.
In many cases the person who sold you the fund receives an ongoing kickback from one or more of these fees. Sometimes they are paid once (from the load), and sometimes they are paid on an ongoing, annual basis. This generally means that you and the financial services industry have different interests, as they earn their fees no matter whether you make money or not.

With an exchange traded fund you do still pay the expense ratio and the hidden trading costs, but you do not pay any sort of "load" charge, nor do you pay a sales fee. Instead you pay a commission to your broker every time an order is executed--typically $25 to $29 a trade, plus some cents per share for large orders. You will pay that fee once when you buy, and you will pay it again when you sell. Finally, you pay an implicit "spread" when you buy and sell an ETF: The price at which you can buy is slightly higher than the price at which you can sell, and the people who execute the trades for you in the stock market pocket the difference. It's real money, even though you may not notice it at first.

Given this fee structure here's some advice:

  • Prefer "indexed" funds, as the MER fees are much lower.
  • Prefer "market cap weighted" index funds: These funds do not have to trade when companies move up and down in the index, so they should have lower hidden trading costs.
  • Adopt a buy-and-hold approach to avoid incurring the trading fees
  • Minimize your buying: place a few big orders rather than many smaller ones.
  • Always find out how the people you are dealing with get paid.

Now let's look at the advantages and disadvantages of ETFs versus open-ended funds.

Advantages and Disadvantages of Exchange Traded Funds

Exchange traded funds have several key advantages over traditional open-ended mutual funds:
  • ETFs tend to have lower MER fees. This is the main reason why we're talking about them. In the United States this isn't true--they have open-ended funds with even lower fees--and hopefully, eventually, that will happen here in Canada too.

  • The ETF doesn't have to execute redemptions (with a conventional fund you can call your broker and exchange your units for money, this is called a redemption). To turn your ETFs into cash you sell them on the stock market, not back to the fund. This saves the fund money because it has much less work to do, and it's vitally important during a market downturn when many investors rush to sell their units. With traditional funds this incurs high costs as the fund has to come up with the money by selling a large number of stocks while the market is falling. That activity hurts those who stayed in the traditional fund, not just those who panic and sell.

  • You don't have to worry about being a victim of the "market timing" tricks that have been in the news recently, where sophisticated investors flip in and out of a fund extracting a profit at the expense of long-term fund investors. The fund trades on a market, so this attack on the fund simply isn't possible. (This scam depends on being able to place orders to buy and sell the fund with information that came out after the fund's daily price came out. An ETF doesn't have a "daily price" that is set by anyone, it trades on a stock market instead.)

  • You can buy US ETFs on the market like any other US stock, whereas US mutual funds are simply not available to you in an RRSP.

The main advantage, though, is price. That's mitigated somewhat by the main disadvantage:
  • You have to pay $25 to $29 to your broker every time you buy or sell, plus
  • You implicitly pay the difference between the bid and ask spread

Note that your broker only gets paid when you trade. Most brokerages will offer you newsletters, analyst reports, and services that are designed to get you to trade more. Don't.

The way to cope with these trading fees on ETFs is to adopt a buy-and-hold approach. You should do that anyway--it's the only sound way to invest. You should also attempt to minimize the number of transactions, say by purchasing the ETF just once a year, rather than buying in a little every month. This is bad: It is much better to do "dollar cost averaging", where you buy your investments a little at a time and get a fairer, average price.

There is a way out of this trap: A good technique here is to save up money in a no-load/no-fee open-ended mutual fund, such as a money market, or equivalent stock-market index. Once a year transfer all your money from this open-ended fund to your ETFs. You will pay a higher MER on that open-ended fund, but you will have a relatively small amount of money there--the money you've built up over years of investing will be in an ETF, and just the money you've added this year will be in the open-ended fund with the higher MER.

Be careful with this strategy: Check with your broker and find out how long you have to leave your money in the open-ended fund to avoid sales charges. Pick a fund that will allow you to transfer your money to the ETF once a year.

What ETFs Should You Buy

In this section I will draw your attention to the key ETFs that you should be interested in, and what they are. Deciding what proportion of your portfolio should be in each is a subject for a future article, but in general it is much better to split your money between a variety of different kinds of stocks than to put all your eggs in one basket. You'd like some US large stocks, some US small, some overseas, some Canadian, and perhaps some emerging markets or REITs. Don't just buy the TSX-60 and the S&P-500, that's not diverse enough.

You should also know that you can hold just 30% of your RRSP in foreign securities. Fortunately there are two solutions: First, if you hold bonds in your RRSP then simply hold Canadian bonds. Unlike stocks, there is not as much advantage in diversifying bonds internationally, and this will use up a lot of the Canadian content portion of your RRSP.

Second, there are special Canadian ETFs that give you exposure to foreign assets without actually being foreign assets (by way of a complicated scheme involving futures contracts).These have slightly higher fees than holding the foreign assets directly, but they do enable you to use "Canadian content" in your RRSP to gain exposure to foreign equity. For example, instead of using the US ETF "VTI" you can use the domestic Canadian ETF "XSP" (with a slightly higher MER). See below.

The most interesting ETFs for Canadian investors are (as at December 2004):

Symbol Description Asset Class MER RRSP Eligibility
CDN:XBB (formerly XGX) iUnits iBond: SCM Bond Index Cdn. mid-Term Bond 0.30% CDN
CDN:XSP iUnits i500R: S&P 500 Index US Large Cap 0.30% CDN
CDN:XIN iUnits iIntr: MSCI EAFE Index Foreign Large Cap 0.35% CDN
US: VTI Vanguard Total US Market US Total Market 0.15% Foreign
US: VB Vanguard MSCI SmallCap 1750 Index US Small Cap 0.18% Foreign
US: IWM iShares Russell 2000 Index US Small Cap 0.20% Foreign
US: EEM iShares Emerging Markets Emerging Markets 0.75% Foreign
US: VTV Vanguards MSCI US Prime Market Value Index US Large Value 0.15% Foreign
US: VBR Vanguard's MSCI Small Cap Value Index US Small Value 0.22% Foreign
CDN:XIC iShares i60c: TSX S&P-60 Capped Index Canadian Equity Index 0.17% CDN
CDN:XRE iShares iReit: TSX REIT Index Cdn. Real Estate Trusts 0.55% CDN
CDN: XGD iUnits iGold: TSX Gold Index Precious Metals 0.55% CDN

There are of course many others, but these are a few that I think are key. Using these you ought to be able to build a fairly diversified portfolio containing exposure to a variety of asset classes: bonds, US large caps, foreign equities, US small caps, US values and Canadian equities. I have also included a few non-traditional classes such as REITs and precious metals. How much of your portfolio should be in REITs is not well understood--perhaps a lot is ok, perhaps not. Precious metals should play only a small role in your portfolio.

Beware of overlap. In many cases these funds hold the same assets. For example, if you buy VTI as well as XSP you have essentially bought the S&P 500 index twice, as the S&P500 dominates the US total market.

Conclusions

Use Exchange Traded Funds (ETFs) instead of mutual funds. Buy once a year, investing your money in a broad array of ETFs representing diverse asset classes. Do not trade often. Save your money during the year in a no-load/no-fee open-ended fund of some sort, even if it has an unfortuante MER.


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How Mutual Funds Work: Exchange Traded Funds | 4 comments | Create New Account
The following comments are owned by whomever posted them. This site is not responsible for what they say.
How Mutual Funds Work: Exchange Traded Funds
Authored by: Anonymous on Sunday, January 16 2005 @ 07:38 PM EST
Gee Wiz this was a great article. I learned a lot about Exchange Traded Funds.
How Mutual Funds Work: Exchange Traded Funds
Authored by: Anonymous on Monday, January 17 2005 @ 09:10 PM EST
1- The use of normal mutual funds for monthly contributions, with an annual transfer into EFTs,
is a good idea. I would not use a money market fund, though, because it pays so little at
present. If you are willing to assume the risk of owning stocks, buy an equity mutual fund right
away (preferably an index fund), and then convert that into matching ETFs at the end of the year
(e.g., convert your canadian equity index fund into a canadian equity ETF).

2- See comments on Barclays' gold ETF at http://www.shakesprimer.tk/
(essentially, this fund is dominated by just two mining compagnies, so you might as well buy the stocks
directly if these are the companies you are interested in - this will save you the MER on the fund)
How Mutual Funds Work: Exchange Traded Funds
Authored by: Anonymous on Saturday, July 16 2005 @ 06:26 AM EDT
What about Interactive Brokers (www.interactivebrokers.ca).

Sounds like they have a $10/month minimum commission, but their margin rates are substantially lower than offered by any of the bank-affiliated discount brokerages, and they charge only $2/trade on Canadian stocks.

Considering that capgain taxes on buying open-ended index funds as a short-term substitute to ETF's will eat into returns, it may be better off just using a setup with them instead.
How Mutual Funds Work: Exchange Traded Funds
Authored by: Anonymous on Wednesday, July 20 2005 @ 09:13 PM EDT
I am building an etf portfolio and am trying to decide between vti and xsp for the US exposure. My investment horizon is 20+ years and I expect to retire in Canada. Vti is cheaper (MER), but are there currency risks I should consider when making this choice, or will any currency differences "come out in the wash" in the long term? I'm leaning to vti but what I really need to know is are there any dangers in holding it vs. xsp for the long haul.
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