In the fall of 2021, as Evermore was preparing to launch the Evermore Retirement ETFs, we commissioned Pollara Insights to conduct a study of self-directed investors to examine Canadians understanding of Exchange Traded Funds (ETFs).
We discovered that 50% of Canadian self-directed investors did not consider themselves knowledgeable about ETFs, and that’s just the Canadians that have taken steps to handle their all or some of their own investments.
Meanwhile, most Canadians are familiar with mutual funds. According to IFIC (The Investment Funds Institute Canada), there are over $2 trillion in mutual funds in Canada. That is more than five times the assets currently held in ETFs.
Too many Canadians are still in high fee mutual funds. We are going to help change that.
Several decades ago, mutual funds were a welcome innovation that enabled everyday investors to achieve diversification at fees that were reasonable relative to any alternative then available. But today, there are easily accessible globally diversified, low-fee investment solutions, so between their high and hidden fees, and some mutual fund salespeople masquerading as unbiased financial advisors, the mutual fund industry must continue change.
Canadians deserve to understand their alternatives.
How are ETFs and mutual funds the same?
When you drill down to the core fundamental purpose of these two investment vehicles, mutual funds and ETFs are exactly same. They both pool funds together and invest that money in various securities, like stocks and bonds, in accordance with the fund’s investment objective as outlined in the fund prospectus (a prospectus is a document that outlines the details about the fund’s investment objectives, legal structure, and operational details).
The intended benefit is that the investor has easier access to achieve diversified exposure to the markets. How they do this depends on the given mutual fund or ETF. Historically, ETFs have been dominated by index-based funds, whereas mutual funds have been dominated by active managers who charge higher fees in exchange for trying to pick investments that will beat their respective benchmark, which in the long-run, most fail to do. Some ETFs that are actively managed can also have high fees, so do not assume that just because a fund is an ETF that it automatically has a low fee.
How are ETFs and mutual funds different?
The three main differences between ETFs and mutual funds boil down to:
- How they are bought and sold
- Fee structures
Both mutual funds and ETFs are available through direct investing accounts. Direct investing accounts are available at all major Canadian banks, as well as independent alternatives such as Questrade, Interactive Brokers, or Wealthsimple Trade.
However, if you use an advisor you may not be working with one that is licensed to provide ETFs, stocks, and bonds. Most advisors in the bank branches, and some other non-bank investment companies, are usually only licensed to sell mutual funds, they are not licensed to provide their clients with the full menu of best possible options. They are salespeople incentivized to sell you a particular brand.
If you want to buy or sell a mutual fund or ETF, you place the order in your direct investing account or through your advisor.
With mutual funds, the purchase or redemption of the mutual fund units is done by the fund company at the end of the day, calculated at the mutual fund’s unit value at the end of the day.
ETFs, however, trade on a stock exchange so you are free to buy and sell them at any time during trading hours through your direct investing account or through your advisor. With ETFs, you have more control over the transaction price. Sometimes this is highlighted as a big benefit to ETFs, but if you are a long-term investor the difference is essentially irrelevant.
ETFs are bought and sold as whole units, whereas mutual fund units are fractional provided your investment meets the minimum investment requirement. This allows automatic dividend reinvesting plans (DRIPs) to be more hands off for mutual funds because DRIPs with ETFs will frequently have cash leftover. Ultimately however, this residual cash is very small.
Lack of fee transparency has been a serious issue for Canadian investors for decades. Only recently, thanks to the Client Relationship Model 2 (CRM2) rules, investment dealers and advisors were forced to be more transparent about the fees they were charging their clients. It became harder to hide the fees.
Both mutual funds and ETFs have two types of fees. The first is a sales charge or commission to buy and sell the funds and the second is ongoing fund fees.
Mutual fund sales charges
Mutual fund sales charges are transaction-based fees paid directly by investors either at the time they buy the fund or at the time they exit or redeem from the fund.
Most Canadian mutual fund manufacturers (the company that creates the mutual fund) sell funds under several different purchase or sale options. The options relate to the method by which the sales charges are paid. These fees will be shown on your investment statements.
The sales charge applicable under each option and the compensation the advisor may receive, must be disclosed in the Fund Facts document. This is a short summary of the fund’s key information including its composition, costs and historical returns.
Mutual funds may come with the following fee structures:
Front-end sales charge, or “front-end load”
Investors pay a sales commission directly to the advisor at the time they buy securities of the mutual fund. The advisor’s sales commission is deducted from the total amount paid by the investor, which means only the remaining amount is invested in the fund.
Deferred sales charge (DSC), or “back-end load”
Investors pay a sales charge at the time they redeem the mutual fund, rather than at the time of purchase. The rate of the DSC payable by investors when they redeem declines the longer they hold the investment and becomes nil after a specified holding period. This is known as the “redemption schedule.” The DSC paid by an investor is typically around 6% in the first year, declining by 0.5% to 1% each year and usually gets down to 0% after a holding period of typically five to seven years. Note that mutual fund manufacturers generally offer investors the opportunity to redeem up to 10% of their DSC securities annually at no charge.
Thankfully, there is a pending ban on DSC fees expected to come into effect on June 1, 2022.
This option works like the DSC option, but with a shorter redemption schedule of typically three years or less. The rate of the DSC ranges from 2% to 3% in year one, declining by 1% each year, and gets down to 0% after a holding period of 2 or 3 years.
In this case there is no sales commission to advisors either upon purchase or at the time the investor redeems. In other words, there is no front-end or deferred sales charge.
ETF sales charges
Sales charges for ETFs are much simpler. ETFs do not have front-load or back-load fees, the only fees you pay to purchase or sell or those charged by your direct investing account or advisor.
While some direct investing platforms charge no commission at all, most platforms change some amount, usually less than $10 per trade, and some will even offer a number of commission-free trades for new accounts.
The second type of fees are ongoing fund fees.
These include management fees and fund expenses. These fees are paid from fund assets and are paid directly by the mutual fund or ETF itself.
When mutual funds and ETFs disclose their fund performance, the information is always net of these ongoing fees and expenses.
Management expense ratio (MER)
A mutual fund or ETF’s management expense ratio, or MER, summarizes the costs of managing and operating the fund. The MER is the total of the fund’s annual management fees and operating costs expressed as a percentage of the fund’s average net assets for that year.
Included in the MER is the management fee charged by the fund manager, administrative expenses, sales taxes, and in the case of most mutual funds, a trailing commission paid from the fund company to the advisor that sold the fund.
ETFs do not have trailing commissions.
Trading expense ratio (TER)
Brokerage commissions paid by the fund for buying and selling securities within the fund, as well as spreads paid on any derivative transactions, are not included in the MER. Instead, these costs are incorporated into the adjusted cost base (ACB) of the investments on the fund’s balance sheet until they are sold. In other words, they are not shown as expenses on the income statement, nor are they included in the MER.
These fees are represented by the trading expense ratio (TER) which is disclosed separately from the MER in the Fund Facts document for mutual funds and the ETF Facts document for ETFs.
In order to determine the total operating costs of a fund, the TER must be added to the MER. The TER is the total commissions, spreads, and other portfolio transaction costs expressed as a percentage of the fund’s average net assets for the year. For many funds this ratio is very low and often rounds to zero. Because the TER is often negligible, many people ignore it, and incorrectly assume the MER is the total operating cost of a fund.
Know what you are paying for
If you are holding mutual funds in your portfolio, you should be fully aware of the fees you are being charged, and consider the lower-fee alternatives now available to all Canadians.
The universe of ETFs continues to grow and provide Canadians access to many low-fee options, like the Evermore Retirement ETFs.