The consensus among index investing experts is that index investors with small portfolios should invest in mutual funds such as TD’s e-series and those with larger portfolios should invest in index ETFs. The idea is to minimize portfolio costs. However, the best choice depends greatly on how you trade in your portfolio.
Mutual funds tend to have higher MERs than ETFs do, but buying and selling ETFs has the costs of commissions and spreads. Once the investor’s portfolio becomes large enough, the MER savings with ETFs overcome the trading costs. But we can’t determine the portfolio size where ETFs become superior without knowing the investor’s trading habits.
To illustrate what I mean we’ll consider two hypothetical beginner investors: Jack and Jill. Each investor has chosen a portfolio mix of domestic stocks, foreign stocks, and bonds with target percentages for each. Jack chose to invest in mutual funds and Jill chose ETFs.
Jack likes to stay very close to his target percentages. He takes his monthly savings and divides it up across his mutual funds according to his chosen percentages. If one asset class has made a big jump in price he might even remove some money from it and put the money into a fund that is below its target percentage. If Jack had chosen ETFs instead of mutual funds, he would have to pay for 5 or 6 trades every month. With the cost of commissions and spreads, this might add up to a drag of $1000 per year on his portfolio. He is clearly better off in mutual funds until his portfolio becomes quite large.
Jill is much less active than Jack is. Jill just lets her savings build up as cash until it reaches at least $3000. Then she buys whichever ETF in her portfolio is below its target percentage by the widest margin. While her portfolio is small this might cause the ETF she buys to overshoot its target percentage by a wide margin, but Jill isn’t concerned. She knows that the percentages aren’t critical while her portfolio is small. Her percentages will fall more closely into line as her portfolio grows.
From these examples we see that trading style matters quite a bit in choosing between ETFs and mutual funds. We also see that it is possible for beginners to choose ETFs if they are flexible about asset allocation percentages in their early investing years.