The ETF dilemma

One of my goals for this month was to decide whether to switch my retirement investments from the index funds I currently hold to an ETF-based portfolio. For the uninitiated, here's a quick rundown of the two types of funds:

• Index Funds - These are mutual funds that track a specified stock index. You can purchase these funds either directly from the company that manages the fund, or through a broker, and the price of the fund is updated at the end of each day. Since these funds have fairly low turnover, their management expense ratio (MER) is lower than for actively managed funds. Index funds are not usually subject to loads or trading commissions, although they often have a minimum purchase amount. Because there are no transactional costs to purchase these funds, they are popular for dollar-cost-averaging.


• Exchange Traded Funds - Like index funds, ETFs track a stock index, but the funds are traded directly on the stock exchange, and must be purchased through a broker. The price of an ETF fluctuates with its associated index throughout the trading day. These funds have even lower MERs than index funds, but they are subject to the broker's trading commissions, so there is a cost to buy or sell the funds. As a result, ETFs are more popular for lump sum investing, since they save money when transactions are less frequent.

It's taken me a while to get my head around the index fund vs. ETF debate, and I've got a few factors to consider:

• Cost - This really gets to the heart of the difference between the two investment vehicles. The index funds I currently hold are reasonably low-cost, with a blended MER of 0.39% for my whole portfolio. However, if I were to switch into the ETF equivalents of these funds, I could reduce this further to 0.19%. On a portfolio of $50,000, that difference translates to a savings of $100 per year. In order to switch over to ETFs, however, I will have to pay the commission for each fund that I buy. At the current size of my portfolio, it will take 1-2 years for the reduced MER to offset the trading commissions.


• Tracking - The price of my current index funds remains fixed throughout the trading day, but ETFs have intra-day fluctuations as they track changes in their associated index. This means that ETFs would facilitate a more real-time tracking of my portfolio's value. While this appeals to me from a dataholic perspective, it scares me a bit to be able to track to-the-minute variations in my long-term investment value.


• Timing - Although I use the innocuous word "switching" to describe what I'm contemplating here, what I'm really considering is cashing in all my investments, and then immediately buying back into the market. This exposes me to market fluctuations between when I sell and when I buy. I know that the difference is not likely to be significant, and you can never guarantee that your timing will be perfect, but I'm uneasy with the prospect of performing this switch on my entire portfolio, especially in our current market conditions.


• Choice - The decision of whether to switch aside, I also need to decide which ETFs I'll buy if I make this change. Fortunately, there's lots of discussion on this topic, and a handful of Vanguard and iShares (for Canadian indices) funds should work just fine.

My portfolio is right on the verge of making this change worthwhile from a cost perspective. With the MER savings paying back my commissions within 2 years, it seems like the right time to make the switch. However, I just rebalanced my portfolio a few months ago, and given the volatility in the market at the moment, I really don't want to "cash out" with this much uncertainty.

I think the best thing to do is to hold off until early 2009, and make the switch then. This will put me on an annual rebalancing schedule, and will also allow me to incorporate my year-end bonus (if any) into the transaction. Of course, I'm making the assumption that I'll be more confident about my decision six months from now, but by committing to this plan today, I have time to research my choices, and a deadline to complete the transaction.

So, in the interest of checking off another goal this month, my decision is to switch my retirement investments to an ETF-based portfolio by February 28, 2009.

On an unrelated note, I'd like to apologise in advance to the author of next February's Loonies And Sense posts for any stress he may feel over the next several months.