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Reader Mail: ETFs vs No Load Mutual Funds and Starting a Financial Journey

It’s been a while since I’ve responded to reader mail through a blog post, but I thought this had some great questions that come up often.  This particular reader has questions regarding ETFs vs no load mutual funds, and where to start on his financial journey.

1) Is it true that ETFs and no-load mutual funds are the same? If not, what are their differences and advantages?

2) As a new investor, who recently opened a Questrade account based on your brokerage comparison, I need your advice of where to start in creating a low-cost portfolio. Here is my current financial situation:

  • I have $8,000 in HELOC debt (which I would like to pay off sooner than later.
  • Have a $20,000 interest-free car loan
  • Mortgage: 174,000
  • Would like to have an emergency fund
  • Focus on conservative/moderate growth investments
  • Focus on investments that produce a monthly income
  • Variable mortgage rate: 2.2%
  • Income: Over $80,000
  • Province: Ontario

I would be interested in your opinion of where I should begin in order have reasonable financially secure future.

ETFs vs No-Load Mutual Funds

Seems like the reader is looking to jump head first into investing and is looking for answers.  To start, ETFs and no load mutual funds are not the same.  No load mutual funds are mutual funds without the upfront (or backend) fees.  Yes, there are actually mutual funds out there that charge client fees for the privilege of buying the fund (yes I’m serious).  A number of mutual funds with sales loads offer them as a deferred sales load.  While they do not charge anything upfront, the longer you hold the mutual fund, the lower the sales load they charge once you sell the fund.

While there is a place for mutual funds, the only mutual funds that I like are the low cost index kind, which mean they are no-load AND they have a low management expense ratio (MER).  I like index mutual funds for portfolios that are just starting out (<$20k) as there are no commissions for buying/selling, in addition to the ability to purchase partial units (fixed dollar amount contribution per month etc).  A recommended place to start is with the TD e-Series funds.

Once the portfolio balance grows, it will soon approach time to switch to ETFs.  While an index ETF will essentially have the same holdings as an index mutual fund, there are a couple of differences.  One significant difference is that ETFs (Exchange Traded Funds) trade like stocks on a stock exchange.  This basically means that the investor will have to pay commissions for buying and selling the ETF (some brokers offer free ETF trades).  So with the extra fees of buying/selling, why would an investor switch from mutual funds? Although ETFs also have MERS, they are generally lower than the equivalent index mutual fund.  Over time, and with growing portfolios, this can add up to thousands per year in savings.

The Next Step?

The reader is also looking for the next step for a secure financial future, but appears to be focused on investing.  To me, paying off debt is the top priority as it frees up cash flow and relieves a psychological burden. But there are a few prerequisite steps to complete.

  1. Establish Positive Cash Flow – With a decent income and a manageable mortgage, creating a budget to create positive cash flow is a must.
  2. Start an Emergency Fund – While it’s debatable on how much to put in an emergency fund, I think it’s a good idea to have one.  As the reader is interested in starting one, I think enough cash to cover 3 months expenses is a good place to start.  Once that is established..
  3. Pay off Debt -The HELOC mentioned is likely charging 4% interest (prime + 1%), although it’s a relatively low rate, its gotta go.  I would leave the car loan until the term is up because it’s free money.  Once the HELOC is payed off, time to focus on the mortgage by paying it off as soon as possible.  If not already setup, increase payment frequency to accelerated bi-weekly, top up payments and pay lump sums when cash is available.  For more mortgage tips, check out how we paid off our mortgage in three years.
  4. Invest – Once debt is eliminated, it’s time to take all that freed up cash flow and invest.   As I mentioned, if just starting out, I like low cost index mutual funds, and then move to index ETFs when the portfolio becomes larger. Since the reader already has a discount broker account opened, here is an example of a low cost ETF portfolio to consider.

What are your thoughts?  Do you have anything to add to the reader questions?

Do you have a financial question?  Feel free to send them to me here.  Note that due to high volume of email, it may take several days to get a response, but I’ll get to it as quickly as possible.

Disclaimer:  This article should be used for informational purposes only.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 11 comments… add one }
  • Goldberg August 7, 2012, 11:14 am

    I disagree with #4. Begin the habit of investing now.

    A good ETF/fund is relatively stable and returns over HELOC rate + taxes on cap gains/dividends.

    But the point is to develop the habit now, even if its only a small amount like $1000 per year. You should call yourself an investor now.

    It will motivate you to learn more about investing and in five/ten years (when most debt will be paid off), your investment account will still be small but you will have many years of habit, knowledge and experience. That has value in itself.

    Otherwise, I agree. Pay HELOC first, and mortgage second. Car loan wasn’t really 0% since you could have had a $2000 rebate or so if paid 100% cash. But inferred rate is still lower than the mortgage and early repayment won’t save you interest… so minimum payments only.

    Myself I do a 45/45/10 for early repayment/investment/”emergency fund,” more if I recently needed to use the emergency fund.

  • Elbyron August 7, 2012, 2:42 pm

    In this case, I would put paying down the HELOC as a higher priority than the emergency fund. Don’t put money into a 1.4% savings account while you’re still paying a 4% loan which itself can act as a source of emergency funds. Once the HELOC is paid off, keep it open with a zero balance for a while and start saving your extra earnings to build the emergency fund. As long as you’re not tempted to use it, I would keep the unused HELOC open as long as your bank allows it, or until you decide to port your mortgage to another bank.

    I somewhat disagree with Goldberg about investing while holding debt. There is no difference between doing that, and leveraged investing – which means gambling with money you don’t have. While developing good habits is important, adding an investment portfolio just means more finance stuff to keep track of. But if you don’t mind the additional hassle, it doesn’t hurt to put a small amount (I would say even less than $1000/year) into investments just to feel good about it and maybe learn something.

    My final suggestion is to hold off on extra mortgage payments for now. Once #2 and 3 are completed, start putting money in safe, easy-to-access investments (like a Bonds index fund). Then when the interest-free period on the car loan expires and suddenly has a high interest rate, liquidate the investments and pay off as much of that loan as you can. Depending how high the rate is, maybe even borrow from the HELOC to pay it off. Then repay the HELOC till it’s again back to zero. When all other loans are finally paid off, then work on paying down the mortgage faster.

  • Steve August 7, 2012, 2:50 pm

    I would jump into ETFs right away. Just to highlight how expensive mutual funds are, suppose I have a small portfolio of $5000 and want to invest over a period of one year. A typical mutual fund will charge you 2%, which works out to $100/year. By contrast, an ETF will charge a more reasonable 0.5%, meaning $25/year. Add your commission for buying and selling, and you’re left with total costs of $35-$85. The difference will only grow with your investment horizon and portfolio size.

  • Steve August 7, 2012, 3:10 pm

    On another note, I passed my CFA Level III exam :)))))))

  • Elbyron August 7, 2012, 7:16 pm

    @Steve
    The article didn’t suggest investing in “typical” mutual funds, it specifically referred to low-cost index funds like TD e-series, which have MER rates between 0.5 – 0.8%. For the brokerage fees on ETFs to be worth it, you need a much bigger portfolio, usually 50K is recommended – but it obviously also depends on how often you want to add, withdraw, and rebalance.

  • Elbyron August 7, 2012, 7:35 pm

    Oops, was looking at the wrong rates. TD e-Series range from 0.33 to 0.53%. With ETFs, you have a lot more choices, and you can build a reasonably varied portfolio with MERs in the range of 0.06 – 0.23%. However, commission costs are going to be more than $25/year since you’re hopefully not buying just one ETF. I’d say that even with a $10/trade discount broker you’re still looking at at least $40/year (to invest in 4 ETFs on an annual basis).

  • Steve August 8, 2012, 11:52 am

    Good analysis Elbyron. I was over-simplifying just to show differences between the average mutual fund and ETF. One note though… You can achieve decent diversification with just two ETFs: a large cap diversified ETF and a mixed corporate/government bonds ETF. You COULD take it a step further and look for a real estate or alternative investments ETF to invest in, but it likely has extremely low liquidity and a very high MER. I’m not even sure if we even have any of those in Canada anyway. So just two ETFs would work wonders.

  • Steve August 8, 2012, 12:00 pm

    Actually, I did a quick scan of the iShares ETFs and there IS such an ETF. And there ARE ETFs that offer broad asset class diversification all wrapped into one — with a high MER (>0.80%).

    But here’s what I would do for quick and efficient diversification: XIU for broad equities (MER 0.17%) and XBB for corporate/government bond mix (MER 0.30%). Plus, these are some of the most liquid ETFs so you know you won’t be chewing the sleeves off your shirt over an absurd bid/ask spread.

  • bob August 8, 2012, 12:46 pm

    Global Couch Potato has a post up that actually compares the costs of various scenarios of ETFS vs Index Mutual Funds. He has also built a spreadsheet to help you figure out which is more advantageous depending on your portfolio size, specific funds, etc. Excellent stuff.

    http://canadiancouchpotato.com/

  • Elbyron August 8, 2012, 3:04 pm

    @Steve
    While iShares used to offer some of the best ETFs, they’ve been beaten now that Vanguard came to Canada. Instead of XIU and XBB, why not VCE (MER 0.10%) and VAB (0.23%)? Pretty much the same diversification and good liquidity, and you can’t argue with lower fees! If you only made 1 trade per year for each ETF, the total cost in brokerage and MER fees would be less than the MER on the equivalent e-Series funds when the investment amount is over $8000 (using the spreadsheet from Canadian Couch Potato, and assuming $9.95 per trade).
    But the problem with just 2 ETFs is that while you may have a broad asset class, you’ve focused entirely on Canada. I don’t know of any good ETFs you can buy on a Canadian exchange that would give you exposure to the U.S. or world markets, but it is possible to buy US-listed ETFs. However, you either need a source of U.S. funds, or deal in large enough amounts to justify Norbert’s Gambit – as any other means of converting to US dollars will end up costing more than what you’d save on the MER.
    I suppose someone could do a little of both: hold Canadian ETFs and use e-Series for foreign investment. As long as your Canadian portion was larger than $8000, you would still be able to save more on MER than the brokerage fees would cost you.

  • Michael Kohn August 11, 2012, 5:23 pm

    I agree with you.
    Pay off the debt ASAP and then start to manage the cash flow for lucrative invest.
    The only positive loan is the car ones

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