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(Steve Cole)
(Steve Cole)

Portfolio Strategy

Commission-free ETFs: A big boost for small investors Add to ...

So much for the big knock on exchange-traded funds as an investment for the masses.

With the introduction of commission-free ETF trading at three online brokerage firms, you can now buy yourself a diversified portfolio without incurring potentially expensive trading fees. Particularly for beginners and investors with small accounts, it’s time for a re-think of ETF investing.

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Whether you’re looking at ETFs or mutual funds, there are two layers of cost to consider. There’s the cost of buying and selling, and the cost of owning.

Zero-commission ETFs are like the no-load mutual funds sold at banks and through several independent fund companies. But ETFs are much cheaper to own than these and virtually all other mutual funds. In their classic form, ETFs are nothing but robotic index-tracking funds. They’re inexpensive to run, and investors benefit from that.

ETFs have been available without commissions for years in the U.S. market, but they only made it to Canada in September. Scotia iTrade introduced them and Qtrade Investor and Virtual Brokers followed suit (Note: These and other firms are included in my latest ranking of online brokers).

There are now close to 270 ETFs listed on the Toronto Stock Exchange, which is far more than anyone needs to build a well diversified portfolio. Scotia iTrade offers 46 ETFs with no commissions, Qtrade offers a menu of 60 and Virtual Brokers offers 100.

Expect to find mainly Claymore, Horizons and iShares products offered on a zero-commission basis, with a few BMO and PowerShares as well. None of the ETFs that the U.S. firm Vanguard will soon list on the TSX are included, and neither are ETFs from a small Canadian player called XTF Capital. Virtual Brokers is unique in including 25 U.S.-listed ETFs as well on its zero-commission list.

Whichever broker you choose, expect to compromise when you match up your wish list of ETFs with the funds that are available to buy and sell at no cost. For example, none of the three brokers offers the iShares S&P/TSX 60 Index Fund , the largest exchange-traded fund by far in Canada, and none offers the iShares DEX Universe Bond Index Fund . XIU is an investor-friendly choice for investors who want cheap access to the 60 biggest publicly traded Canadian companies, while XBB is the entire Canadian bond market in a single convenient bundle.

It’s noteworthy that all three brokers offer the lowest-cost ETF for exposure to the Canadian market, the Horizons S&P/TSX 60 ETF . The management expense ratio for this ETF is a stunningly low 0.08 per cent, but it’s debatable whether it’s a mainstream product because of its “synthetic” structure. Instead of holding the stocks in the 60 index (like XIU does), HXT uses financial instruments called derivatives to achieve the same returns. There are pluses and minuses to this approach, but it adds a layer of complexity that some investors may not want to deal with.

HXT is the most extreme example of how cheap ETFs are to own. But paying commissions to buy and sell this or any other ETF can reduce the benefit of low fees.

The more you trade ETFs, the more you save with the new zero-commission offers. But let’s focus on the buy-and-hold investor who wants to set up a portfolio and then stick to modifications and adjustments after that. The most dramatic savings apply to beginners and other investors who have small accounts. Most online brokers charge a minimum $29 per online trade until you reach $50,000 in assets, and then they cut your costs to just below $10 per trade.

Imagine you have $10,000 to build a portfolio with six ETFs and you plan to rebalance your portfolio every six months or so to ensure your stock and bond weightings are where they should be. That could easily work out to 12 trades per year, which would cost a total of $348 at $29 a pop, or a very hefty 3.5 per cent of your investment.

Here, you see why ETFs have never been a good option for small accounts. Given the stock trading commissions at many online brokerage firms, they’re just too expensive to buy and sell. Commission-free ETFs changes all of that. Now, the beginner has no reason not to look at ETFs as an alternative to mutual funds, which can often be bought and sold at no cost.

Investors with accounts of $50,000 or more in assets also benefit with commission-free ETFs, but the savings are less dramatic because they start with lower trading costs. The same applies to customers of the online broker Questrade, which has a minimum commission of just below $5 for all customers, and Virtual Brokers, which has a commission plan where you pay 1 cent per share with a minimum cost of 99 cents.

However big your account, commission-free ETFs provide a no-cost gateway to the cheapest portfolio available to investors who choose the fund approach over selecting individual stocks. Let’s use the Virtual Brokers list of ETFs as an example:

-Bonds: The Claymore 1-5-Year Laddered Government Bond Index ETF and Claymore 1-5-Year Laddered Corporate Bond Index ETF , with management expense ratios of 0.17 per cent and 0.28 per cent, respectively.

-Canadian stocks: The Horizons S&P/TSX 60 Index Fund, with the aforementioned 0.08 per cent MER, and the iShares S&P/TSX Completion Index Fund at 0.58 per cent (XMD covers mid-size companies).

-U.S. stocks: The BMO U.S. Equity Hedged CAD Index ETF , at about 0.25 per cent.

-International stocks: The BMO International Equity Hedged to CAD Index ETF , at about 0.5 per cent.

In a portfolio with a weighting of 20 per cent each in CBO, CLF and HXT, 10 per cent in XMD and 15 per cent each in ZUE and ZDM, you end up with a weighted management expense ratio of 0.28 per cent. That’s a great deal made better if you can build the portfolio for free.



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