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Are ETFs getting a free ride in cost comparisons with mutual funds?

A reader believes this to be the case. “I think the [cost] comparison is not fair if annual trade fees for ETFs are not included in the equation,” he wrote in a recent e-mail.

Exchange-traded funds cost much less than mutual funds to own, but there are stock-trading commissions to be paid when you buy and sell them. These commissions are rarely factored into cost considerations for ETFs, but they can add up. You might even be better off with a mutual fund instead of an ETF in some cases.

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The reader based his case on the TD e-series of low-cost index mutual funds. So let’s compare the TD Canadian Index Fund e-series, with a management expense ratio of 0.32 per cent, against the TD Canadian Index ETF (TTP), with an MER of 0.08 per cent.

On an MER basis alone, TTP outclasses its mutual-fund sibling. But what if you make contributions to your investment account on a monthly basis?

It’s easiest to buy TD’s e-series of index funds if you have an account at online brokerage TD Direct Investing. TD Direct charges zero to buy and sell e-series products, and it charges just about $10 to buy and sell stocks and ETFs. If you bought some TTP shares on a monthly basis, that’s $120 a year or so in total commissions. On a $50,000 account, that’s the equivalent of a fee of 0.24 per cent over a year. Add that to the 0.08-per-cent MER and you have a cost identical to the e-series mutual fund.

Let’s factor in five more trades a year for random extra contributions to your investment account and to rebalance your holdings once or twice a year (rebalancing means selling a bit of your winning investments to buy a bit more of your losers). Those five extra trades ($50 a year) add an additional cost of 0.1 per cent to your ETF annually, for a total cost of 0.42 per cent. We’re now at a point where the TD Canadian Index Fund e-series is cheaper than TTP, even though the latter has a considerably lower MER.

There are at least a couple of competitors to TTP with MERs as low as 0.06 per cent. Also, some online brokers charge in the $5 to $9 range for trades. A few charge nothing to buy, though in some cases they apply commissions when you sell. Still, there’s a lesson here for cost-conscious investors who think ETFs are the one and only choice for cheap index investing. When you factor in trading costs, a mutual fund might be the cheaper choice.

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