Monday, April 26, 2010

Portfolio Alternatives

Last week we analyzed the mutual fund holdings of an investor named Tim. Now we’ll look at ways to replace his mutual funds with alternatives that don’t cost as much. The goal will be to construct a portfolio with the same asset allocation but lower costs. The two approaches I’ll look at are TD e-series index funds and exchange-traded funds.

Tim’s asset allocation is as follows:

56% Canadian stocks
16% foreign stocks (including US)
28% bonds

The blended MER of his holdings is 2.45% per year.

I won’t address the question of whether this is an appropriate allocation for Tim. I believe that it is within a reasonable range, but this discussion is a distraction for the question of whether Tim’s advisor is worth the extra costs. The starting point is to see how cheaply Tim can get essentially the same portfolio as he has now.


TD e-series approach

To match this allocation with TD e-series funds, Tim could get the following:

56% TD Canadian Index Fund (MER 0.31%)
8% TD US Index Fund (MER 0.33%)
8% TD International Index Fund (MER 0.48%)
28% TD Canadian Bond Index Fund (MER 0.48%)

The blended MER of these holdings is 0.37% per year. This is a savings of 2.08% per year over Tim’s current mutual fund holdings. For a $100,000 portfolio, the savings are $2080 per year.

ETF approach

Another approach is to buy exchange-traded funds (ETFs) that trade like stocks on stock exchanges. The main advantage of this approach is that the MERs are even lower. Here is a possible ETF allocation to roughly match Tim’s current allocation:

40% iShares S&P/TSX 60 Index Fund (ticker: XIU, MER 0.17%)
16% iShares S&P/TSX SmallCap Index Fund (ticker: XCS, MER 0.55%)
28% iShares DEX Universe Bond Index Fund (ticker: XBB, MER 0.30%)
16% Vanguard Total World Stock ETF (ticker: VT, MER 0.30%)

The blended MER of these holdings is 0.29%. Tim would save $2160 per year less trading costs based on a $100,000 portfolio. Trading costs include trading commissions (often $10 per trade) plus half of the bid-ask spread on each trade. These spreads tend to be very low on the ETFs chosen here.

Comparison

The choice of whether to go with TD e-series funds or ETFs is mainly based on costs. Trading costs will depend on how often money is added to the portfolio and how many different accounts the portfolio is split into. Combining this with the MER costs, the TD e-series funds will look better below a certain portfolio size, and the ETFs will look better for larger portfolios.

Conclusion

The alternatives presented here are not exactly the same as Tim’s current holdings, but they are fairly close. The main advantages are that the approaches described here are

1. Much cheaper
2. Better diversified
3. Free of punitive deferred sales charges (TD only charges up to 2% for selling within 90 days of purchase)
4. Under Tim’s personal control

Having greater control over his portfolio is also a potential disadvantage for Tim. There would be no advisor to hold his hand and possibly stop him from panicking the next time the market drops. Only Tim can decide if the advice he gets is worth the added cost of his mutual funds. The important thing is to understand what these costs are to make an informed decision.

4 comments:

  1. I'm with you. Big time.

    I'd rather save >2% right at the start and forgo the hand-holding of a planner.

    If needed, Tim can hire someone for a few hours of cosultation.

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  2. @Mark: You make a good point about hiring a planner for a few hours. However I've heard some people say that it can be difficult to find a planner to work on this basis. I'm told that some planners use a face-to-face meeting to pitch additional services like creating a multi-thousand-dollar write-up of a plan. This may be good for investors who need it, but many investors would just want to pick the planner's brain for a couple of hours and go away to do the rest on their own.

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  3. The other option is to take some portion of your portfolio and let a planner invest it in costly funds like Tim was in, and consider that payment for creating a plan, asset allocation, and whatever other hand-holding is needed... and then go off and invest the rest in e-series or ETFs.

    That does seem to come off as a little dishonest, and also assumes the planner/salesman is worth the cost to you!

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  4. @Potato: This might work in some cases. However, many planners won't deal with small portfolios and if they do, I suspect they wouldn't pay too much attention to the portfolio allocation for very small portfolios.

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