Index funds versus exchange-traded funds

This article compares index mutual funds versus index exchange-traded funds (ETFs), to help readers decide which portfolio building block is best for them. Some investors also use both, in different accounts, or even in the same account.

Both mutual funds and ETFs come in index or active varieties. This article assumes that the reader is already convinced of the long-term benefits of passive management.

Comparison table

Index mutual funds and index ETFs have some key differences that an investor should be aware of when making a choice. Some of these differences are covered in the following table:

	Index mutual fund	Index ETF
Number & diversity	Relatively low number of funds available in Canada, but cover most of the main asset classes(a)	Very large number of ETFs available on TSX & US exchanges, covering almost all possible wishes
How to buy	Purchased directly from mutual fund company, or in brokerage account	Requires a brokerage account
Dollars or units?	Buying and selling done in dollar amounts, orders can be entered at any time of the day	Transactions involve whole ETF shares
Trade execution	End-of-day pricing of trades, exactly at the net asset value (NAV)	Immediate pricing of trades during market fours, at market prices (which may differ slightly from the NAV)
Preauthorized contributions	Easy, starting at $25 per month	Not generally possible
Distributions	Typically automatically reinvested	Typically paid in cash (can be automatically reinvested if the distribution is worth more than one share of the ETF)
One-time costs	Most have no purchase or sale costs from the fund(b), but some brokers have started charging purchase and sale commissions	Has purchase(c) and sales fees (commissions); bid-ask spreads; buying US-listed ETFs may lead to currency conversion costs
Ongoing costs	Management expense ratio (MER) usually >0.5%(d)	MER typically <0.4%, and as low as <0.1%(e)
Bookkeeping in non-registered accounts	Done by the fund	May require manual tracking of adjusted cost base
One fund solutions available	Yes, MER typically ≥1%(f)	Asset allocation ETFs, MER ~0.2-0.25%

(a) Some asset classes important for some investors such as Real estate investment trusts (REITs), Real Return Bonds (RRBs) or gold, for example, are not covered by index funds.

(b) But watch out for possible early redemption fees.

(c) Some discount brokerages do not charge commissions to purchase ETFs; some don't charge to sell as well.

(d) The least expensive index mutual funds in Canada are TD's e-series, which are in the 0.3-0.5% range.

(e) For example, in March 2021, Vanguard Canada's ETF lineup had MERs between 0.06% and 0.39%, and it was possible to build a four ETF portfolio with MERs ranging from 0.06% to 0.22%.

(f) See for example the Simplii portfolios, which mix CIBC index funds, or the Tangerine Core portfolios.

The established rule-of-thumb used to be that index mutual funds were more suitable for small, frequent purchases (for example in systematic investment plans), while index ETFs were cheaper for one-time major purchases. Now that some discount brokers have started charging clients to trade mutual funds, and that some brokers offer commission-free ETF transactions, that rule is no longer universally applicable.

The brokerage industry is turning the old rules on their head by charging investors to buy mutual funds while at the same time offering zero commissions on ETFs. No-fee trading is now available for at least some ETFs at many brokerages, including Questrade, National Bank Direct, BMO InvestorLine, Scotia iTRADE and Qtrade. (...) If you’re a fan of the e-Series funds and you’re able to continue holding them with no trading costs, then don’t let me talk you out of it. But if you’re looking to build a low-cost, low-maintenance index portfolio, then asset allocation ETFs at a zero-commission brokerage are likely to be a better choice.

— Canadian Couch Potatio blog

Using both

If the investor has a brokerage account, then index mutual funds and index ETFs can be used simultaneously. While that strategy may have some cost savings, it doubles the number of positions in a portfolio, compared to an all-ETF or all index-fund portfolio.

For the strategy to yield cost savings, mutual fund transactions must be free and ETF transactions must imply paying commissions to the broker. If that is true, and the investor wants to add small amounts every month into his account, then index funds would be used (to avoid commissions, and the inconvenience of having to trade during the market hours). When the amount accumulated in each index fund warrants it (perhaps every couple of years), the index funds would be sold and the money reinvested into ETFs, with a single trading commission per fund. The process would then be repeated, with new contributions going to index funds.

While this was possible at many brokers in the past, the recent trend has been free ETF transactions but commissions being charged on mutual fund trades, making the "using both" strategy less interesting, or even unattractive.

About e-funds

Note that if the investor wants to use the TD e-funds, the "using both" strategy has traditionally only been possible with a TD brokerage account. However, during summer 2019, more brokerages began to offer TD e-funds. However, again, since March 2022, some brokers have begun charging clients to buy and sell mutual funds (including the e-funds).

Further reading

• Financial Wisdom Forum topic: "Index mutual funds vs ETFs"