Latest / How Canadian Markets Work / Episode 88: ETFs vs. Mutual Funds (The Small Saver's Math)

Transcript

Episode 88: ETFs vs. Mutual Funds (The Small Saver's Math) · How Canadian Markets Work

0:00
In our previous deep dive into ETF creation and
0:02
redemption, we were looking at how financial
0:06
markets are effectively held together by this
0:08
invisible rubber band. Right, that arbitrage
0:10
mechanism. Exactly. We explored how designated
0:13
brokers operate. purely on self -interest, they
0:16
step in to arbitrage the market price of an ETF
0:19
whenever it drifts away from the actual value
0:22
of its underlying assets. Yeah, and that arbitrage
0:24
mechanism, it really is the engine of the entire
0:27
ETF structure. Like when the market price trades
0:29
at a premium, those designated brokers... they
0:33
buy the underlying securities. Then they exchange
0:36
them for newly minted ETF units and sell those
0:39
units to just pocket the difference. And it's
0:42
that action itself that forces the ETF's price
0:45
back into alignment with the net asset value.
0:47
Exactly. It is an incredibly efficient piece
0:50
of financial plumbing. It really is. And because
0:52
that plumbing is so efficient, There is this
0:55
prevailing narrative in the investment world
0:57
that ETFs have essentially rendered mutual funds
1:00
obsolete. Oh, for sure. You hear it everywhere.
1:03
Right. The assumption is that ETFs are strictly
1:05
better. They have lower fees, secure your tax
1:08
efficiency, and they give you absolute control
1:11
over your execution. Yeah, the common knowledge.
1:13
Exactly, the common knowledge. So for this deep
1:15
dive, we're taking a stack of sources that pit
1:18
ETFs directly against mutual funds to see if
1:21
that common knowledge actually holds up under
1:23
scrutiny. Which is a very necessary comparison.
1:26
Right. Our mission today is to cut through the
1:29
hype. We're going to examine the mechanics of
1:31
trading flexibility, the reality of transaction
1:34
costs versus management expense ratios, the MERS,
1:38
and the underlying tax structures. And we really
1:40
need to look at how running a standard dollar
1:42
cost averaging strategy can completely change
1:44
the math for you. Right. Because when we look
1:46
closely at the mechanics, we find that this widely
1:49
accepted superiority of the ETF wrapper, it's
1:52
actually highly conditional. Highly conditional,
1:54
yeah. And to understand why, I mean, we should
1:57
probably start with the most obvious operational
1:59
difference and investor experiences, right? The
2:01
execution mechanics. OK, yeah. So the actual
2:04
process of getting the asset into your portfolio.
2:07
Exactly. With an ETF, the experience really just
2:11
mirrors trading a single stock, doesn't it? It
2:14
does. It trades on an exchange continuously throughout
2:17
the session. So you log into your brokerage,
2:19
you're looking at a live order book, you see
2:21
the bid and the ask, and you can dictate your
2:23
entry point using a limit order. Right. There
2:27
is an undeniable sense of agency there like you
2:29
are dictating the terms of your execution Yeah,
2:32
you have total control intraday, but a mutual
2:35
fund it operates on an entirely different architecture
2:38
It's known as forward pricing forward pricing,
2:41
right? Yeah They do not trade intraday at all
2:43
when you place a buy or sell order for a mutual
2:46
fund You are effectively just entering a queue.
2:48
Okay, the transaction doesn't actually process
2:51
until the market closes And that's when they
2:52
calculate the net asset value per share the NAVPS
2:56
exactly Exactly. They take the closing prices
2:57
of all the underlying assets, subtract any liabilities,
3:01
and divide that by the outstanding units. Which
3:03
means, and this is the crazy part to me, if I
3:06
submit an order at like 10 .30 in the morning,
3:09
I'm committing to a transaction without actually
3:12
knowing the exact price I'm going to receive.
3:14
Yeah, you just have to wait and see. It feels
3:16
so counterintuitive. It's almost like going to
3:18
a restaurant and ordering dinner off a menu that
3:21
has no prices and just trusting the math at the
3:24
end of the night when the check comes. That's
3:26
a great analogy, actually, and it can feel incredibly
3:28
unsettling if you're used to the immediacy of
3:31
exchange trading. Oh, absolutely. You know, that
3:34
forward pricing mechanism, it exists for a very
3:37
specific structural reason. It prevents arbitrage
3:40
against the fund itself. Okay. How so? Well,
3:43
if a mutual fund allowed you to purchase units
3:46
at a known historical price, while the current
3:49
market was actively rallying, you would effectively
3:52
be extracting value from the existing long -term
3:56
investors in that fund. Oh, I see. Because you'd
3:58
be buying in at yesterday's cheap price. When
4:01
the assets are already worth more today. Exactly.
4:04
So forward pricing ensures that intraday market
4:06
timing is structurally impossible. But more importantly,
4:10
for the average investor, it provides a really
4:12
unique execution environment. Because every single
4:15
investor who transacts on a given day receives
4:18
the exact same price. Exactly. So there is zero
4:21
market impact regardless of the size of your
4:24
order. Correct. And crucially, and people forget
4:26
this, There is no bid ask spread. Wow. Right.
4:30
Yeah. You are interacting directly with the fund
4:32
company, not some secondary market maker who
4:35
needs to extract a premium for providing liquidity.
4:39
You know, I have to push back a bit on this whole
4:41
obsession with execution control anyway. Let's
4:43
hear it. If you are building a multi -decade
4:45
portfolio. Sweating the execution price at 10
4:48
15 a .m. Versus the closing price at 4 p .m.
4:51
Seems entirely pointless is mostly just noise
4:54
Honestly, right and couldn't that intraday access
4:56
actually be a behavioral liability like the structure
5:00
of an ETF actively facilitates impulsive trading
5:02
Oh, it absolutely does. I'm glad you brought
5:04
that up. The friction inherent in mutual funds,
5:08
the fact that you cannot execute immediately
5:10
and you simply have to wait for the daily pricing
5:12
that often acts as a behavioral safeguard. It
5:15
forces a pause. Yes. Intraday liquidity is always
5:18
marketed as this premium feature, but for a buy
5:21
and hold index investor. The ability to panic
5:25
sell during a volatile midday session is probably
5:28
the least valuable tool at their disposal. It
5:30
just makes it too easy to make a bad decision.
5:33
Exactly. And that behavioral friction, it actually
5:36
ties directly into the mechanics of how these
5:38
products are priced, and more importantly, how
5:40
those prices hide transaction costs. OK, let's
5:43
get into the costs. Because if trading flexibility
5:45
isn't necessarily a net positive, we should look
5:48
at the absolute cornerstone argument for ETFs.
5:51
which is the fee structure. Right, the narrative
5:54
that ETS are just mathematically cheaper. Which
5:56
they are, generally speaking, right? They are,
5:59
but the narrative often relies on a massive false
6:01
equivalence. How do you mean? Well, investors
6:04
frequently look at the management expense ratio,
6:07
the MR, of a passive broad market index ETF,
6:11
and they compare it to the MR of a legacy actively
6:14
managed mutual fund. Oh, right, like an apple
6:17
to oranges comparison. Exactly. They are conflating
6:20
the product wrapper with the underlying investment
6:23
strategy. The vast majority of that active mutual
6:26
funds cost difference comes from paying a portfolio
6:29
management team to attempt to beat the market,
6:31
not from the structure of the mutual fund wrapper
6:34
itself. So to evaluate the wrappers fairly, we
6:37
have to isolate the variables. We need to compare
6:40
an index ETF directly against an index mutual
6:44
fund that tracks the exact same benchmark. Precisely.
6:47
And when you run that specific comparison, the
6:49
gap in the MER narrows significantly. So the
6:52
ETF still has a slight edge, right? Generally,
6:54
yes. The ETF will maintain a slight edge in pure
6:57
management fees. But the analysis is totally
6:59
incomplete if you just evaluate the MER and a
7:02
vacuum. We have to incorporate the transaction
7:04
costs associated with actually acquiring the
7:07
asset. OK, let's run that through a standard
7:09
dollar cost averaging model based on the data
7:11
in our sources. Let's do it. So imagine an investor
7:14
deploying smaller tranches of capital. Say you're
7:18
contributing $200 every single month. for 10
7:21
years. OK, so that is $24 ,000 in total principal
7:24
invested over the decade. Right. And we will
7:26
model a 7 % gross annualized return for both
7:30
assets just to keep the comparison clean. Sounds
7:33
good. So if we model the ultra low cost index
7:37
ETF carrying a 0 .06 % MER, that portfolio grows
7:42
to roughly $34 ,503 over the decade. OK, 34 grand
7:48
in change. Yeah. But if we model the equivalent
7:50
index mutual fund with an admittedly higher amir
7:54
of 0 .90 % Pretty typical fee gap. Right. The
7:58
final balance sits at about $32 ,954. So if we
8:02
are strictly looking at the drag of the management
8:04
fee, the ETF wrapper preserves about $1 ,550
8:09
more wealth. Exactly. The ETF seems to be the
8:12
clear winner. But, and here's the huge catch
8:15
that assumes frictionless trading, which simply
8:18
isn't the reality for many retail brokerage accounts.
8:20
Not at all. Because the ETF trades on an exchange,
8:24
you are often subject to a commission for every
8:27
single execution. And that fundamentally alters
8:30
the math. Right. If your brokerage charges a
8:32
standard $10 commission, those 120 monthly purchases
8:36
represent $1 ,200 in direct trading costs. Boom.
8:41
That $1 ,550 EMIRA advantage, it's immediately
8:46
reduced to just $350 over a decade. And we still
8:49
haven't even accounted for the bid -ask spread
8:51
we discussed earlier. Oh, exactly. Because every
8:54
time you cross the spread to buy that ETF, you
8:56
are paying a hidden premium. Because market makers
8:59
aren't charities, right? Right. They take on
9:01
the inventory risk of holding the ETF, and they
9:04
demand compensation for providing you with that
9:06
immediate liquidity. So the spread essentially
9:08
acts as a micro tax on every single transaction.
9:11
Yes. And over 120 purchases, that spread drag
9:16
can easily consume the remaining $350 advantage.
9:20
So for this specific strategy frequent smaller
9:23
contributions, the structural costs of the ETF
9:26
wrapper entirely neutralize its lower management
9:29
fee. That is wild to think about. And, you know,
9:33
there is also a structural cash drag issue here
9:35
that we shouldn't ignore either. The fractional
9:37
shares issue. Exactly. Unless your brokerage
9:41
explicitly supports fractional ETF shares, which
9:43
many still do not, an ETF requires you to purchase
9:47
whole units. Right. So if your target asset trades
9:50
at $85 and you are contributing $200 a month,
9:54
you can only afford to buy two shares. Which
9:56
is $170. Right. And that leaves $30 just sitting
10:00
idle in cash in your account doing absolutely
10:02
nothing. While mutual funds, by design, process
10:05
fractional amounts to the absolute penny, you
10:08
allocate $200, you acquire exactly $200 worth
10:11
of the underlying asset. No cash drag at all.
10:14
None. And honestly, the psychological benefit
10:16
of just putting the process on autopilot is significant.
10:18
Oh, yeah. A mutual fund allows for seamless,
10:21
automated clearing from a checking account right
10:23
into the market. You are fully invested without
10:26
the friction of manually calculating whole shares
10:29
or making sure you log in during market hours
10:31
to place the Which means, for someone running
10:35
a standard DCA strategy, especially early on,
10:38
the index mutual fund is likely the superior
10:40
vehicle, despite the higher MER. Yes. For small,
10:45
regular contributions, the mutual fund often
10:47
wins. But let's look at how that math shifts
10:50
as your portfolio scales up. Because obviously,
10:53
the relationship between flat transaction costs
10:55
and percentage -based fees isn't linear. No,
10:57
it's actually an inverse relationship. Once a
11:00
portfolio achieves sufficient scale, the math
11:01
we just discussed completely inverts. OK, let's
11:04
run the numbers on a bigger account. Let's look
11:06
at a $500 ,000 portfolio. Nice round number.
11:09
Right. So the 84 basis point difference between
11:12
our mutual fund at 0 .90 % and our ETF at 0 .06%.
11:17
That difference equates to a fee drag of $4 ,200
11:21
annually. $4 ,200 every single year. Yes. Wow.
11:27
And at that scale. paying a $10 flat commission
11:30
to deploy some new capital is literally a rounding
11:33
error. Exactly. A commission is just a static
11:36
one -time penalty incurred only when capital
11:38
is actually moved. But an M -year, that is a
11:42
continuous percentage levied against the totality
11:45
of your accumulated wealth day in and day out.
11:47
So as your asset base grows, minimizing that
11:50
percentage fee becomes the absolute overriding
11:53
priority. Exactly right. So the mechanics kind
11:55
of dictate that a hybrid approach might actually
11:58
be optimal over a long investing life cycle,
12:00
wouldn't you say? How do you mean? Well, you
12:02
could utilize the automated fractional capabilities
12:05
of an index mutual fund. to aggregate capital
12:08
without transaction friction during your accumulation
12:11
phase, right? When you're making small monthly
12:13
deposit. Okay, yeah. And then periodically, perhaps
12:16
once a year, you liquidate that mutual fund position
12:19
and roll the bulk capital into the ultra low
12:21
mirror ETF. That way you minimize the ongoing
12:24
fee drag on the core large portfolio. That is
12:27
a highly efficient strategy. It leverages the
12:29
mechanical strength of both wrappers perfectly.
12:32
It's like a win -win. Well, there is a catch.
12:34
There's always a catch. That strategy relies
12:36
on the assumption that you can move capital between
12:38
the two products without any negative consequences,
12:42
which requires us to look at the other major
12:44
mechanical difference between ETFs and mutual
12:47
funds, the underlying tax structure, the hidden
12:50
tax trap. Exactly. This is where the actual plumbing
12:54
of how these funds handle redemptions becomes
12:57
incredibly critical. Let's look at the mutual
12:59
fund first. Sure. When a mutual fund experiences
13:02
significant outflows, say a macroeconomic event
13:05
spooks a large contingent of investors and they
13:08
all just panic and submit redemption requests,
13:11
the fund manager needs to generate the liquidity
13:13
to pay them all out. Right. And the manager doesn't
13:16
just hold massive cash reserves to cover that,
13:19
because holding cash creates a drag on the fund's
13:22
performance. So they have to go into the open
13:23
market and actually sell off portions of the
13:26
underlying portfolio. Exactly. They have to sell.
13:29
If the fund has held those assets during a prolonged
13:32
bull market, selling them crystallizes capital
13:35
gains. Yes. And here is where the structure of
13:39
a mutual fund becomes highly problematic in a
13:42
taxable environment. Because of how those gains
13:44
are treated, right? Exactly. Under tax regulations,
13:47
the mutual fund entity cannot simply retain those
13:50
crystallized gains. It is legally required to
13:52
distribute them. OK. But the investors who panicked
13:55
and triggered the sales, they have already redeemed
13:58
their units and exited the fund. Oh, wow. So
14:02
they are gone. They are gone. Therefore, those
14:05
capital gains are distributed pro rata to the
14:07
remaining unit holders. To the people who just
14:09
sat there and did nothing. It's like going out
14:11
to dinner with a huge group of people. Right.
14:13
And a couple people order the lobster, they drink
14:15
the most expensive rine, and then they leave
14:17
early before the check arrives. And you, the
14:19
guy who just had a salad, you get stuck paying
14:22
the tax on their massive meal. That is exactly
14:25
what it's like. A passive buy and hold investor
14:27
who did absolutely nothing can be forced to recognize
14:30
a taxable capital gain simply because other participants
14:34
in the fund decided to liquidate their positions.
14:37
You are effectively subsidizing the panic of
14:39
active traders. It is a widely recognized structural
14:42
inefficiency of the mutual fund wrapper. It is
14:45
highly susceptible to the behavior of other investors,
14:48
which is pretty terrifying, honestly, which brings
14:50
us back to the. ETF creation and redemption mechanism
14:53
we covered in the previous deep dive. How does
14:56
the ETF wrapper solve this massive tax flaw?
15:00
through what's called the in -kind transaction.
15:02
OK, the in -kind transaction. Right. When large
15:05
institutional investors or designated brokers
15:07
want to redeem ETF units, the ETF issuer does
15:11
not necessarily need to sell the underlying assets
15:14
to raise cash. Like the mutual fund manager had
15:17
to. Exactly. Instead of selling, the ETF issuer
15:20
can simply hand over a proportional basket of
15:22
the actual underlying stocks or bonds directly
15:25
to the designated broker in exchange for the
15:27
ETF units being redeemed. because no cash is
15:30
actually changing hands on the open exchange.
15:33
It's essentially just an asset swap. There's
15:35
no sale recognized within the fund itself. Precisely.
15:38
The in -kind redemption mechanism allows the
15:40
ETF to systematically flush out the underlying
15:42
assets with the lowest cost basis, and it does
15:45
it without triggering a taxable event for the
15:47
fund. That is brilliant. It really is. This means
15:50
the remaining ETF shareholders are completely
15:52
shielded from the capital gains generated by
15:54
the redemption activity of others. The structural
15:56
advantage there is just massive. You are totally
15:59
insulated from the behavioral... volatility of
16:03
the broader investor base. You are. But I think
16:05
we need to contextualize this because that tax
16:08
efficiency isn't universally applicable, is it?
16:11
No. It is not. Like if an investor is holding
16:13
these assets inside a tax -sheltered account,
16:16
like a 401k, an IRA, or any registered retirement
16:19
vehicle, does this underlying mechanism actually
16:22
matter to them at all? It doesn't. Inside a registered
16:25
tax -advantaged account, the account structure
16:27
itself completely shields the capital gains.
16:30
Okay. So if a mutual fund distributes a massive
16:32
capital gain to your IRA because of internal
16:35
redemptions, there's no immediate tax consequence
16:37
to you anyway. So the tax efficiency of the ETF
16:40
wrapper only provides a tangible economic benefit
16:42
when the athets are held in a standard non -registered
16:46
taxable account. Exactly. The environment completely
16:49
dictates the utility of the tool. The mutual
16:52
funds' fatal tax flaw is completely neutralized
16:55
if it is just held in the correct account type.
16:58
Which is why relying on blanket statements like,
17:01
you know, ETFs are always superior. is so dangerous.
17:04
It's very dangerous. An investor really needs
17:06
to align the specific mechanics of the product
17:09
with the specific constraints of their own portfolio
17:11
architecture. Let's kind of synthesize the mechanics
17:14
we've covered today because we've gone through
17:16
a lot. We have. If you are operating a large
17:18
portfolio in a taxable environment, The ETF is
17:22
structurally superior. Undeniably. The sheer
17:25
weight of the ongoing AUM fee makes the ETF's
17:28
lower MER a mathematical necessity. Yeah. And
17:31
the in -kind redemption mechanism protects you
17:33
from external capital gains distributions. Right.
17:35
But conversely, if you are utilizing tax sheltered
17:38
accounts and executing a systematic dollar cost
17:41
averaging strategy, you know, regular smaller
17:44
contributions, the index mutual fund is remarkably
17:47
competitive. Oh, absolutely. The ability to execute
17:50
automated fractional purchases without crossing
17:54
the bid ask spread or paying those flat commissions,
17:57
that often totally overcomes the slight disadvantage
18:00
in the management expense ratio. So it just requires
18:02
a dynamic approach. The optimal wrapper for a
18:05
$5 ,000 portfolio is very likely the suboptimal
18:09
wrapper for a $500 ,000 portfolio. Exactly. Investors
18:13
need to evaluate their execution costs and account
18:16
structures continuously as their capital scales.
18:19
Right. What got you there won't necessarily keep
18:20
you there. Exactly. And, you know, as a final
18:23
thought to leave you with, I think it is worth
18:25
returning to the fundamental architecture of
18:27
the ETF itself. OK. We talked about that invisible
18:30
rubber band of designated brokers keeping the
18:33
market price tied to the net asset value. Right.
18:36
The arbitrage mechanism that ensures you are
18:37
always paying a fair price on the exchange. Think
18:40
about the prerequisite for that mechanism to
18:42
actually function. The underlying securities
18:44
must be highly liquid. OK. The designated broker
18:48
needs to be able to instantly buy or sell the
18:51
basket of underlying assets to execute the arbitrage.
18:54
But consider this. What happens during a severe
18:58
systemic liquidity crunch? Like a major market
19:01
panic? Yes. If an ETF holds a basket of illiquid
19:05
corporate bonds or, say, volatile microcap equities,
19:09
and the secondary market for those assets just
19:11
seizes up during a panic, the designated brokers
19:14
literally cannot execute their trades. Oh, wow.
19:17
So the arbitrage mechanism strains. It strains.
19:19
And if it breaks, the market price of the ETF
19:22
can decouple wildly from the actual value of
19:25
its under... underlying assets. That's terrifying.
19:27
The very structure that provides you with intraday
19:29
liquidity under normal conditions could theoretically
19:32
fail to protect your execution price right at
19:34
the exact moment the market demands liquidity
19:36
the most. Meaning the wrapper itself could become
19:38
a massive source of risk. Well, that is a vital
19:41
reminder that financial engineering always carries
19:44
inherent tradeoffs. And understanding those underlying
19:47
mechanics is really the only way to accurately
19:49
price that risk. So keep questioning the plumbing
19:52
behind your portfolios and we will catch you
19:54
on the next deep dive.