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Mutual funds or ETFs? Before you start choosing individual funds for your portfolio, you need to answer a bigger question: should you use index mutual funds or ETFs?

The short answer is that if you are new to DIY investing, if you plan to make small monthly contributions or if your portfolio is smaller than $30,000, index mutual funds are almost certainly the better choice. In fact, it's usually best to stick with index mutual funds if your account is less than $50,000 or so. That would include most education savings accounts, Tax-Free Savings Accounts and small RRSPs.

Although ETFs grab most of the headlines, humble index mutual funds have a lot going for them: most are "no-load" funds, which means you can add and withdraw money without incurring any sales charges or commissions, and it's easy to set up monthly preauthorized contribution plans. They're also more user-friendly. If you're new to managing your own portfolio, buying mutual funds is easier than learning the mechanics of buying and selling ETFs on a stock exchange.

As well, there's evidence that people trade ETFs too often, while mutual funds are well suited to buy-and-hold investors. In fact, most charge a redemption fee if you sell them before two or three months. This may sound like a penalty, but it's actually a good reminder that such funds are for long-term investors (like you), and not for traders.

There are a few problems with Canadian index mutual funds, however. For starters, most of them are far too expensive. Many have management expense ratios (MERs) of 1 per cent or more. (By comparison, U.S. investors can build index mutual funds portfolios for one tenth as much.) Indexing only works when costs are kept low: when it's just as expensive as active management, most of the advantage is wiped out.

That said, some index mutual funds are worth a look. At the top of the list are TD's e-Series funds, which have the lowest fees in Canada, ranging from 0.32 per cent to 0.50 per cent. This family of funds covers our core four asset classes: Canadian stocks, U.S. stocks, international stocks and Canadian bonds. (There are no e-Series funds for the other asset classes we looked at, such as emerging markets, REITs and real-return bonds.)

The main obstacle to using these funds is that they're only available to TD's online customers. You can access them by opening a TD Mutual Funds account and then converting it to an e-Series account online, or by opening an account with TD Waterhouse, the bank's discount brokerage. Customers of other online brokerages can't access these funds, unfortunately. Nor can you walk into your local TD branch and ask to open an e-Series account in person.

If you're not a customer of TD, the next best options are the index mutual funds offered by RBC and Altamira, which charge between 0.62 per cent and 0.70 per cent. The selection here is even more limited, however; Altamira's Canadian Index Fund includes only large-cap stocks, for example, while RBC's bond index fund includes only government issues and not corporates. They'll do the trick for small and simple portfolios, but if you plan to make a significant investment in index mutual funds, it's worth considering an account with TD.

A number of other index fund families are available through fee-only advisers, including Pro-Index Funds, PIE Funds and Invesco PowerShares funds. Some of these are also available through discount brokerages, but only in versions that include built-in commissions. While these may be appropriate for investors who work with advisers, do-it-yourselfers should stick to the less expensive funds we've discussed above.

If by now you think that index mutual funds are right for you, you can skip ahead to the next chapter. When it comes time to build your portfolio, flip to Chapter 10 and use the funds we recommend for the Global Couch Potato (Option A or B). All you'll need to do is adjust the overall mix of stocks and bonds to suit your own situation.

Should you use index mutual funds or ETFs? Use this checklist to quickly decide whether to build your portfolio with index funds or ETFs

Choose index mutual funds if:

  • you’re investing an amount less than $30,000 to $50,000
  • you plan to make small, regular contributions
  • you plan to stick to the core four asset classes
  • you’re not comfortable buying and selling ETFs in a discount brokerage account

Choose ETFs if:

  • your account is at least $30,000 to $50,000
  • your brokerage charges a commission of no more than $10 per trade
  • you plan to make infrequent, lump-sum contributions
  • you want to include asset classes that are not available through index mutual funds (REITs, emerging markets, real-return bonds, corporate bonds)
  • you’re comfortable using a discount brokerage to place trades

Author Dan Bortolotti is a senior editor and columnist at MoneySense magazine. His Canadian Couch Potato blog was chosen by The Globe and Mail as the country's best investing blog in 2011. Excerpted with permission. The MoneySense Guide to the Perfect Portfolio ($9.95) by Dan Bortolotti is available at Chapters, Shoppers Drug Mart, Loblaws, London Drugs, Wal-mart Canada and other retailers across the country.