Some of my readers ask why I bother with ETFs when I could save the MER costs and buy the index stocks directly. For example, instead of owning the popular iShares index fund XIU, why not save the 0.18% per year and buy the 60 Canadian stocks that make up the index this ETF tracks? The short answer is that replicating XIU cheaply is difficult.
Let’s look at a fictitious example. Dan has a sizable portfolio. His allocation to XIU is $500,000. This fund’s MER of 0.18% costs Dan $900 per year. With such a large portfolio, Dan seems like a good candidate to try buying the TSX 60 stocks directly to save some of that $900.
Let’s assume that Dan’s XIU shares are all held in tax-sheltered accounts, such as RRSPs, RRIFs, or TFSAs, so that we don’t have to worry about capital gains taxes. We’ll also assume that Dan pays only $5 per trade and that the spreads on TSX 60 stocks average one cent lost per $50 traded (0.02% per trade).
If Dan wants to own all 60 stocks in exactly the right proportions, he will have to make 60 trades (not counting the initial sale of XIU). This will cost Dan $300 in commissions and another $100 in spreads. Even if Dan has his money split across multiple tax-advantaged accounts, he can just own a different subset of the TSX 60 in each account. So, the initial cost is $400.
Whenever Dan adds new money to his accounts he will have to make 60 trades if he wants to maintain the correct proportion of each of the 60 stocks. This is another $300 in commissions and a small amount in spread costs (assuming the deposit is relatively small).
Dan will incur the same $300 in commission costs whenever he makes a withdrawal. There is the added complication that the account he is withdrawing from may not have any shares in one of the stocks. This will force Dan to sell more of a different stock and then make two trades in a different account to get back in balance. So, withdrawals could easily cost Dan closer to $400 in commissions.
Depending on how often Dan makes contributions or withdrawals, trading costs might add up to more than the $900 per year Dan is trying to save.
Another source of costs for Dan is changes to the TSX 60 index. For example on 2013 June 24, the weight of Valeant Pharmaceuticals increased in the TSX 60 index. To account for this, Dan either has to add new money to his accounts to buy more Valeant, or he has to sell some of each of the other 59 stocks to buy more Valeant. The cost for this is about $300.
Dan also owns some bonds and some U.S. stocks along with his Canadian stocks. He has target allocation percentages for each of these three categories. He finds that he doesn’t have to rebalance often, but when he does, he gets hit with another $300 in commissions for changing his allocation to Canadian stocks.
Being Flexible about Following the Index Exactly to Save on Costs
An obvious way for Dan to save on costs is to be a little flexible about owning the 60 stocks in exactly the correct proportions. The problem is that this has a cost, even if this cost is not visible.
For example, Dan might choose to own only the 20 biggest stocks instead of all 60. This will instantly cut his trading costs by two-thirds. Unfortunately, this will slightly increase the volatility of Dan’s portfolio which leads to volatility losses. This might seem like a small effect, and it is, but we are comparing it to a small MER of 0.18%. Under one set of assumptions, the volatility losses amount to 0.06%, or about $300 per year.
If Dan is clever, he could examine all these factors and find an optimal strategy that minimizes the total of all these costs (commissions, spreads, index changes, rebalancing, and increased volatility drag). This strategy would involve following the index fairly closely, but not so closely that Dan has to make a lot of trades each year.
Let’s suppose that Dan manages to find a strategy that is expected to cost him only $700 per year instead of the $900 XIU is charging him. Exactly how much work should Dan do to save this $200 per year? Personally, I’d much rather just buy XIU and spend more time with my family and friends.
On the subject of what I like to buy, I like Vanguard’s VCN as a replacement for XIU. VCN is more broadly diversified and has a lower MER.
It is difficult to replicate stock indexes at lower costs than the MERs of the best index ETFs. It would likely take a multi-million dollar portfolio and a complex strategy to get total portfolio costs below these MERs. And even then, a complex strategy would give only slight savings. Why bother? I prefer to just buy the best index ETFs.