Me and My Money

Switching to ETFs

Posted March 14, 2012
Originally Published March 5, 2012

Contemplate standing at the edge of a dock on a lake.   It’s steamy hot and you’ll feel better after taking the plunge.  Dipping a toe chills you, despite the soaring mercury.  “C’mon, do it!“ you urge yourself.  Even so you hesitate. 

You look to the shore.  Surely it would be easier to wade rather than jump.  You could walk in up to your hips then do a graceful dive into the deeps.  Or, you might simply stand in the water half in and half out -- bottom wet, top dry.   

Still, you hesitate.  Which will bring the most pleasure with the least pain? 

This just about sums up the conundrum facing dozens and dozens of you who have written to me recently about switching from a mutual fund or stock portfolio into Exchange Traded Funds (ETFs). 

For quick review:  ETFs are investments which track or mimic a given index such as the S&PTSX Composite or the Dow Jones Industrial Average.   The majority are passive meaning there is no active management (buying and selling stocks or other securities.)  They are listed on a stock exchange and each one has a ticker symbol.  In most cases, you pay a trading fee to purchase or sell ETFs and management fees are a fraction of those charged by mutual funds. On average, equity or stock mutual funds in Canada have annual management expense ratios or fees (MERs) of between 2.25 and 2.5 per cent.  The majority of ETF fees clock in at less than .5 per cent and some are as low as .07 per cent.

In addition to wanting lower fees, many investors have become dissatisfied with the performance of mutual funds or frustrated by their lack of transparency.  This has created an increasing appetite for ETFs. 

But, as Norman Waits wrote, “I have a $237,000 RRSP in eight mutual funds none of which I understand.  I want to change to an ETF portfolio such as you write about in your book, Count on Yourself, but I’m not sure the best way to do this.”

Waits also noted that while he has a good relationship with and trusts his current, long-time advisor she is less than enthusiastic about the change.   You can hardly blame her since the ETF switch will eliminate the sales commissions she receives from Norman’s mutual fund portfolio.

There are three basic ways to convert to an ETF portfolio.

1.  Plunge – sell everything and reinvest in ETFs. 

2.   Wade and dive – dump poorer performing funds or stocks and reinvest the proceeds in ETFs.  Or, sell the allowable quantity of funds over time to avoid sales commissions and put that money into ETFs as it becomes available.

3.  Half and half  - hang on to all your existing investments and create a separate portfolio with new money invested in ETFs.

The advantage to the plunge is that you have a clean slate.  All that’s needed is to determine what asset allocation suits you (e.g.; 10 percent cash, 30 per cent bonds, 40 per cent Canadian stocks, 20 per cent US stocks) and which ETF products to buy.

The plunge approach is also simple and when it comes to investing simplicity has a lot going for it.

The disadvantage is that there may be deferred sales charges (aka DSC or back end loads) to pay on mutual fund units purchased in the last few years.   However, you are probably better off paying the sales fee and starting fresh rather than holding on to poor quality mutual funds.

Another disadvantage is that there will be trading fees to pay on the sale of stocks and, depending on your brokerage, possibly on mutual funds sales.  Again, if you have sub-par stocks or funds the exit fee, in the form of a trading commission, may be a small price to pay.

The gradual wade and dive conversion to an ETF portfolio will lessen sales charges, especially since you can usually redeem 10 per cent of mutual fund units without incurring DSC fees. However, it creates a bit of a management nightmare.  You will have years of a lopsided portfolio and likely will be in the dark about your asset allocation. 

The half and half approach does have the advantage of keeping good quality investments in your portfolio but the disadvantage of leaving malingerers there also.   More sophisticated investors might choose this strategy if they are able to distinguish the good from the bad and also if they can interpret their asset allocation properly.  The latter is easier to do with a stock and bond portfolio than with a mutual fund portfolio. 

For example, I have an RRSP statement from a reader in hand which lists her asset allocation thusly:  Cash – 12 per cent, Fixed Income – 32 per cent, Equities – 21 per cent, Mutual Funds – 35 per cent.  But wait, mutual funds aren’t an asset class unto themselves.  In this case, the reader has three balanced funds each holding varying amounts of cash, bonds and equities so the asset allocation listed is completely wrong.

Another issue faces those who hold bonds individually rather than bond mutual funds.  Should they be sold in favour of bond ETFs?  On balance, you are probably better off waiting until the bond matures and then reinvesting the money.   There is also the risk of loss if a bond is worth less currently than you paid for it.  On the flip side, if you hold a bond outside a registered account and you purchased it prior to the interest rate slide, there may be a capital gain if you sell.

Those who are converting to ETFs from either stock and bond or mutual fund portfolios have a number of options.  There is no single right way to proceed.  I prefer to take the plunge but there is an argument in favour of the more gradual approaches.  Before you do anything, evaluate yourself, your knowledge, your comfort level and the costs involved.

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