TFSA: Index Funds vs. ETFs

Both index and exchange-traded funds are types of mutual funds that are passively managed. They are designed to track a specific exchange, as oppose to mutual funds that aim to beat an exchange. For example, a TSX index fund would consist of many major Canadian companies. If the fund performs as it should, year after year it should fluctuate very closely to its respective tracking exchange. So what's the difference between Index funds and ETFs and which ones should you buy? Let's get in the lab and crunch some numbers.

Index Funds

Index funds are sold by the company managing the fund, for example you buy TD e-series directly through TD's broker. These index funds would not be available on the market to external investors who do not have an account at TD. Given that Index funds operate on MERs, purchasing and selling them will often be free of charge. We will discuss e-series heavily in throughout this blog as they are currently the cheapest index funds directly available to Canadians.

Exchange Traded Funds

ETFs are also index funds but openly traded on the market. This has two key implications, you now have to pay a commission to purchase/sell the fund and it has access to a greater pool of investors. The brokerage company will not be the entity managing an ETF you purchase. On the positive side, EFTs can be cheaper than standard index funds. A popular company that has the cheapest ETFs out there is Vangaurd. While being an American company, Vangaurd is increasingly providing new products targeted towards Canadians.

So it all comes down to balancing the need to have a discount broker and pay transaction fees to purchase a cheaper product, or simply to get a slightly more expensive product for no other fees.

TD E-series (Cheapest Canadian Index)
Given that e-series are currently the cheapest index funds available, we will use them as a basis for comparison. Here are the fees associated with e-series:

Table 1: MER associated with common TD E-series*

Canadian Stock Index (TDB900) MER: 0.33%

U.S. Stock Index (TDB902) MER: 0.35%

Canadian Bond Market Index (TDB909) MER: 0.50%

International Stock Index (TDB905) MER: 0.54%

Average: MER: 0.43%

The MERs are background fees charged. You do not see them ever passing as fees in your account transactions and they are not included in the performance assessment of an index. The four funds mentioned are some of the main e-series available (17 in total). On the TD Canada Trust e-series page you can find information on all of their available e-series (link here). To put the MER in perspective, it costs $43 per year on a $10,000 investment that is equally balanced between the four funds. That’s right, for $43 you can own a wide scope of the market that consists of hundreds of individual stocks and bonds!

If you are interested in getting started with opening an e-series account with TD, click here to learn (Article Coming!) more about how you can do this. The minimum amount required to open an account is only $100 and there are completely no fees for purchasing or selling e-series (although there is a 30-day minimum holding period).

Vangaurd Index (ETF)

Now let’s compare this to the Vangaurd indexes (ETF). Vangaurd in a non-profit company that is the biggest provider of index funds and currently manages around $3 Trillion in assets. If you are American, you can open an account directly through vanguard and purchase indexes that way. Unfortunately for Canadians, the only way to purchase Vanguard funds is by buying them as ETFs. Never-the-less, here is a look at the MER of some common Vangaurd indexes:

Table 2: MER associated with common Vangaurd ETFs

Vangaurd Canada ETF                           MER: 0.09%
Vangaurd Emerging Markets ETF          MER: 0.29%
Vangaurd S&P 500 ETF                         MER: 0.13%
Vangaurd Canadian Aggregate Bond     MER: 0.19%
Average                                                   MER: 0.175%

On a $10,000 investment equally balanced between all 4 index, the yearly fee would be around $17.5. This represents a near 60% discount from e-series. But! There are transaction fees not accounted for. If we assume each transaction costs $5, a total of 8 transactions per year would cost $40 (assume biyearly contributions). This would now make e-series the cheaper option. One of the fantastic options with e-series is the ease to add to your investments continuously throughout the year without having to worry about transaction fees. This is no longer the case when you have to pay a commission. If you have significantly more money to invest, ETFs can become a better option as depicted below:

Table 3: Comparing TD e-series and Vangaurd ETFs

As the table above shows, unless you have a substantial sum e-series would be a cheaper option. By linear interpolation, the break-even point would be around $15,700 under the estimated fee structure. The take away message here is that unless you have a substantial sum, it may not be worth the time dealing with opening an account with a broker and paying commission for trading ETFs. 

Keep an eye out for Vangaurd, they have recently released new indexes that target specifically Canadian Investors. If Vangaurd was to begin offering investment accounts directly to Canadians, they would clearly become the best option for Index investing. Many more blogs to come expanding index funds, stay tuned!

- Yinvestors.

Notes: 

• Currently Questrade provides free purchases of ETFs (although you still pay fees for selling). If you are looking to get investing in index funds, Questrade may a great starting place due to this promotion.
• The MERs of e-series have actually been increased slightly across the board during June 2015. The fees used to be: TDB905 (0.5%), TDB900 (0.31%), TDB902 (0.33%) and TDB909 (0.48%).  

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