Prudent portfolio management requires the investor to address a few key questions.

First, what is the appropriate asset allocation mix between bonds and equities that will achieve my long term needs for cash flow and sound sleep?

Second, how will each of those asset classes be executed with actual investments?

There are several routes to go:

  • direct purchase of stocks and bonds
  • exchange-traded funds (index-based)
  • active mutual funds
  • passive mutual funds (index-based)

Third, who is going to do this?

  • Will I do all of this myself, or hire and trust someone else?
  • If I hire someone, what are they worth to me?

When things turn ugly for a prolonged period (currently two years in global markets), investors inevitably look for culprits. The guns point eventually to the “fat” mutual fund industry and their high management costs (“MERs”).

Direct holdings and index-based holdings significantly reduce your management costs and give you control and ownership of several other aspects of portfolio management. Sound like a no-brainer? Maybe. If you choose index-based investing, you have to believe that a) earning the market return is satisfactory, and/or b) active fund management cannot beat the market anyway (especially after charging their fee!). If you choose direct investing, you will keep all of the return for yourself (thanks to NO management fees) and you have to believe that your own selection of asset purchases will do no worse than the market or the active fund managers.This is a fundamental decision which encompasses many factors before a good decision can be made.

This article discusses the suitability of direct investing, exchange-traded funds and mutual funds.

Maintaining YOUR Investment Goals

It is oft-stated that your choice of asset allocation between stocks and bonds is the most significant decision you need to make, and maintain, in overseeing your wealth. If you buy actively-managed mutual funds, to some extent you are transferring that decision to the “whims” of the fund manager. For instance, recently, one Canadian equity mutual fund kept 57% of its portfolio in cash! And you thought that your share of that was invested in the market! Exchange Traded Funds (“ETFs”) are always fully invested in whatever index to which they are linked. Index mutual funds are largely fully invested; however, they always hold some cash from new contributions and for daily redemptions.

Management Style

Most mutual funds are actively-managed, i.e. you are paying someone to be an expert in buying and selling appropriately to make you money. Index mutual funds and ETFs are passive; they are linked to some market benchmark “index”, and thus hold all (termed “replication”), or most (termed “sampling”), of the stocks contained in that index.

Indexing is not as passive as it seems. For instance, the stock exchanges occasionally add and delete companies from their benchmarks. Also, companies are taken over by other companies and effectively “disappear”. Lastly, some smaller companies (and smaller stock markets abroad) are “thinly traded”, meaning that it may be hard to find a buyer when you wish to sell. These all require active management.

Most indexes weight their holdings proportionately to the market value of all of the companies in that index. This is referred to as “market capitalization”, which means the value of all of the companies outstanding shares times their prevailing market prices. All Canadian investors remember how, only a few short years ago, one stock— Nortel—took off and represented 35% of the entire TSE. Some index funds block exposure to this weighting problem by being “capped”, i.e. they have a policy not to hold more than 10% of any one stock.

Investable Amounts

The mutual fund industry provides ease of access for small investors, who may be able to invest as little as $100 at a time. There are usually slightly larger minimums when purchasing funds through a broker, typically $500-$1000 at a time. Also, some funds strategically direct themselves only to larger investors, with minimums of $10,000, $25,000 or $150,000. ETFs, however, are purchased on the exchanges and, thus, typically have a minimum 100 unit lot size, which means the minimum purchase may be, say, $2,000.

Liquidity

Investors demand liquidity. Mutual funds provide liquidity by allowing unit-holders to redeem their units at the end of any regular business day. To honour this, funds must keep a certain amount of cash uninvested at-the-ready. If there is a significant “run” on a fund, it may be forced to sell some investments, thus triggering capital gains or losses. Investors holding ETFs have liquidity because they can sell their units to somebody else at any minute of the business year through the stock exchange. There may be some degree of risk (likely, small) that there are no buyers on the day you want to sell.

Income Distribution and Reinvestment

Stock investments yield dividend income which is distributed to the unit-holders. For mutual funds, this can either can be paid out in cash or reinvested in more units (“DRIPs’). ETFs, however, cannot reinvest into more units, thus dividends are distributed quarterly in cash. Mutual funds and ETFs both distribute capital gains at the end of the year.

Management Costs (MERs)

A significant advantage of ETFs is that they have lower annual management expense fees than active and index mutual funds. A sample of ETF fees and comparable mutual fund fees appears in the following table.

Annual Management Expense Fee for:
Index ETF ETF Average Mutual Fund with same index as Benchmark Range for Index Mutual Fund
iUnits S&P / TSX 60 0.17% 2.53% 0.59 – 2.30%
iUnits S&P 500 (RSP) 0.30% 2.60% 0.51 – 3.96%
iShares Russell 2000 (US Small Cap) 0.20% 2.73% 0.72%
iShares S&P Europe 350 0.60% 2.69% 0.51 – 4.10%
iUnits MSCI Int’l (RSP) 0.35% 2.58% 0.51 – 3.40%

The following table shows that the higher costs of actively managed mutual funds, as shown in the previous table, on average do not equate to superior returns relative to their underlying indexes over a 10-year time period. Keep in mind, though, that a select number of mutual funds have consistently outperformed their benchmark indexes over a long period of time. 41 out of 539 (7.6%) Canadian equity funds surpassed the TSX Total Return Index over 10 years, but only 5 out of 560 US equity mutual funds offered in Canada outperformed the S&P 500 Index. It’s not easy for a mutual fund portfolio manager to consistently outperform the index!

Stock Index ETF versus
Class of Mutual Funds
(MFs that use the same benchmark index)
1 – Yr. Return* 5 – Yr. Return* 10 – Yr. Return*
TSX Total Return Index ETF versus -7.9% -0.5% 8.3%
Avg. Canadian Equity MFs -6.8% 0.4% 8.1%
S&P 500 Index ETF versus -16.2% 0.5% 9.5%
Avg. US Equity MFs -14.9% -0.7% 6.9%
MSCI Europe Index ETF versus -15.3% 0.4% 10.4%
Avg. European Equity MFs -17.5% -2.0% 5.9%
MSCI EAFE Index ETF versus -14.8% -1.2% 6.7%
Avg. Int’l Equity MFs -17.2% -1.8% 5.6%
* As of Oct 31st, median annual compound returns in Canadian dollars after management expense fees; fees deducted from actual Index returns are 0.2% for TSX Total Return, 0.3% for S&P 500, 0.6% for MSCI Europe and 0.4% for MSCI EAFE (Int’l excluding North America)

Taxes and Turnover

Investments reward with some combination of dividends, interest and capital gains. All three have radically different treatment under Canadian tax law in non-sheltered accounts. Interest is fully taxed at the investors marginal tax rate. Capital gains are only half-taxed at the individual’s marginal rates. Dividends are also taxed at the marginal rates, but receive an alleviating “tax credit” of approximately 20%. In sheltered accounts, all three forms of income are taxed the same: fully, and at marginal rates upon withdrawal from the sheltered fund. Interest and dividends simply arrive; however capital gains must be triggered by a sale of the stock.

Income from Canadian mutual funds/ETFs maintain these same tax characteristics. However, capital gains distributions to non-sheltered accounts from foreign ETFs do not enjoy the one-half inclusion rate.

Active fund managers trade a lot!Turnover” ratios provide some insight into how much buying and selling goes on inside a fund. Turnover is calculated as the lesser of a fund’s purchases or sales divided by the average assets in the fund. The typical equity fund has a turnover of 80-100% per annum. For starters, this costs a lot of brokerage commissions. Also, it can result in a lot of capital gains, which in turn costs tax! Typically, these gains are not known to the investor until T3 slips are produced in March each year, at which point not much can be done to counteract the tax bill.

Index funds and ETFs are passive, by definition, and thus do not trigger many taxable dispositions. This leaves control of the “tax gate” to the investor, who can sell the fund or ETF according to his/her own timetable.

Transparency

This refers to knowing what it is you actually own. Active fund managers are only required to declare their holdings publicly on a semi-annual basis. They don’t wish their holdings to be known on a day-to-day basis for fear of “exposing their cards”. Index funds and ETFs expose their holdings on a daily basis.

Sector ETFs

ETFs are not limited to broad indexes of different countries and also can be purchased for the various industrial sector indexes, as well as indexes for large, medium and small cap companies, and growth and value stocks. Examples include “XIT” and “XLK” that track the Technology sector indexes in Canada and the US respectively, “XLP” that tracks the US Consumer Staples sector, “XMD” that tracks the Canadian midcap index, “PPH” that tracks a basket of global pharmaceutical companies, and “FFF” that tracks the Fortune 500 Index.

The whole global universe of ETFs that trade over stock exchanges is available for Canadian purchasers. The selection of ETFs will continue to expand as more investors are attracted to this efficient form of investing.

The bottom line—for investors who cannot diversify adequately by using a sufficient number of individual stocks, a portfolio that consists of ETFs and a few select mutual funds may achieve the best of both worlds.