For small accounts, mutual funds aren't the only option

The myth that mutual funds are automatically the best choice for new investors or those with small accounts can go unchallenged no longer.

With as little as $2,000 to $2,500 in your account, it can make sense to buy exchange-traded funds, or ETFs, through an online broker. With as little as $50,000, a portfolio of stocks looks economically sensible.

Advisers will never tell you this because there's no money in setting up these kinds of accounts for clients. It's more lucrative for advisers to put small or new accounts in funds or, worse, wrap accounts, which are bundles of funds. In both cases, advisers and their firms receive a steady stream of commission revenue over the years.

It must be said that mutual funds are still a justifiable choice for the small account. Professionally managed, funds are widely accessible - both in terms of the amount of money you need to invest and the places where you can buy them - and you can often invest in them without any purchase fees or commissions.

But funds are also comparatively expensive to own through the fees they charge their customers on an ongoing basis. That's why some investors prefer ETFs and portfolios of individual stocks, both of which are cheaper to own in the long run. Lower fees don't guarantee you higher returns, but they're certainly an advantage to investors.

This holds true for both large accounts and smaller ones. In this edition of the Portfolio Strategy column, we'll look at some guidelines for deciding whether ETFs and stocks make sense as a fund alternative.

First, let's look at someone who wants to get started with investing through regular contributions and has no portfolio. Mutual funds are an ideal way to go here because of the low upfront minimum required investments, and the availability of pre-authorized chequing (PAC) plans.

The Toronto-Dominion Bank and Industrial Alliance fund families deserve recognition for having a minimum initial investment requirement of $100. AIC has a $250 minimum, while most other fund families are at $500 or $1,000.

New investors need to be aware of purchase commissions with mutual funds. No-load funds don't have any, and you can sell your holdings without costs as well (fees may apply if you buy and then sell within a month or two).

Technically speaking, most other funds charge either upfront sales commissions or redemption fees should you decide to sell in the first several years after you buy. However, a growing number of investment advisers, plus virtually all online brokers, offer a wide variety of funds with purchase commissions and redemption fees waived.

ETFs have become a strong competitor to mutual funds because they have low ownership fees and highly competitive returns. ETFs trade like stocks, which means two things. You need a brokerage account, and you have to pay commission fees to buy and sell.

Note: The Claymore family of ETFs has arrangements with some investment dealers to allow clients to make regular, commission-free contributions to its funds once they have made an initial purchase. Generally, though, new investors should typically expect to pay as much as $20 to $29 to buy between one and 1,000 shares of an ETF using an online broker (yes, you can buy any number of ETFs you want). If you were to invest in ETFs on a monthly basis, you could rack up commissions of as much as $348 a year. That's prohibitively expensive until you have upwards of $17,500 in your account.

At that level, $348 in commissions represents just less than 2 per cent of your total holdings. Add the fees that you'll pay to own ETFs to this amount and your total costs will be in line with what many mutual funds charge.

If you make regular investments less frequently, say once per quarter, it's cost effective to replace funds with ETFs with even smaller accounts. Paying quarterly $29 commissions to buy ETFs starts to make sense when you have $6,000 or more in your account.

To calculate the cost efficiency of buying individual stocks, let's assume you want a diversified portfolio with 24 names. At $29 a crack, you're looking at a total commission cost of up to $696. With $35,000 to invest, this total commission cost represents just less than 2 per cent of your holdings.

So far, we've been looking at the first-year cost of buying ETFs and individual stocks. If you take a long-term view, both ETFs and stocks look even more appealing for small accounts. The reason is that you give up far more of your returns to own mutual funds than you do ETFs, while stocks cost you nothing once you've bought them. Let's generously say a portfolio of mutual funds would have fees of 2 per cent annually (these fees are taken off the top, and what's left over is the published return).

If you invested $2,500 in five ETFs, your upfront cost would be as much as $145, or 5.8 per cent, plus an estimated 0.3 per cent extra to cover the fees you pay as an owner of ETFs. That's 6.1 per cent, which seems to suggest that ETFs make no sense.

Now, let's assume the markets deliver a return of 6 per cent annually for five successive years. After fees, your mutual fund portfolio gives you 4 per cent, which adds up to $3,023 after five years.

With a portfolio of five ETFs, your $2,500 is reduced to $2,355 after commissions, and your net return after fees might reasonably be pegged at 5.7 per cent. After five years, you end up with $3,106, or an extra $83.

With stocks, your net returns over time are not affected by ownership fees because there are none. But you may want to do a little buying and selling to keep everything you own in line, and that's going to reduce your gains by as much as $29 per trade. Clearly, it only makes sense to own stocks in a small account if you trade minimally.

One last consideration is the reinvestment of dividends paid by the securities you own. No-cost dividend reinvestment is available for ETFs and stocks, but it's not as easily available as it is with mutual funds. Worst case, owners of ETFs and stocks have to rack up a trading commission every now and then to reinvest dividends.

Canadians have invested close to $550-billion in mutual funds and a major reason is how friendly they are to small accounts. The secret you'll never hear from the fund industry is that ETFs and individual stocks can work well for small accounts, too.

The Dollars and Cents Guide to Investing

Here's how mutual funds, exchange-traded funds and individual stocks might stack up as an investment for small accounts over a five-year period. For comparison purposes, let's assume each of the portfolios described here makes a yearly return of 6 per cent before fees.

A Portfolio of Five Mutual Funds

A Portfolio of Five Exchange-Traded Funds

A Portfolio of 24 Stocks

Notes:

In the ETF and stock portfolios, returns are calculated after reducing the account size to start by the cost of stock-trading commissions.

The Investor Education Fund's mutual fund fee impact calculator was used to assess the impact of fees ( investored.ca ).

The cost of owning the various portfolios refers to the fees reflected in the management expense ratio (MER).

Additional trades in the ETF and stock portfolios may be required to reinvest dividends or for rebalancing purposes.