Dale Jackson

Personal Finance Columnist, Payback Time

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With the Feb. 29 deadline to contribute to a registered retirement savings plan (RRSP) fast approaching, millions of Canadians will be weighing the pros and cons of investing through mutual funds or index-linked exchange traded funds (ETFs).

Most Canadians currently invest for retirement through mutual funds either directly or through company pension plans, but ETFs have become increasingly popular over the past three decades as a less expensive way to add diversification to an investment portfolio.

The right choice depends on the individual investor as well as the individual investment.

Here are a few things to keep in mind if you are torn between a mutual funds and an ETF:

MUTUAL FUND PROS

Mutual funds are the most popular choice for retirement savers because they are the only investment vehicle available to average investors that can provide professional management and diversification.

Thousands of mutual funds are available on the market that focus on just about every sector, sub-sector, geographic region or investment style imaginable.

Professional, or active, managers normally have access to the best research and can pick-and-choose individual holdings and their weightings within the fund.  

Professional investing requires a great deal of education and experience to be successful. It also requires a hard-to-quantify ability to identify and manage risk, especially near or in retirement when the stakes are so high.

Active managers, such as the team led by Warren Buffett, are trained to identify a company’s earnings potential along with possible risks by pouring through quarterly corporate earnings statements, and often establishing direct relationships with management.

They assess the broader sector, market, and economy on macro level and determine if the company’s earnings justify its current price levels.

MUTUAL FUND CONS

There is a cost for professional management in the form of fees. Canada is notorious among developed nations for the highest mutual fund fees.

Annual fees, expressed as the management expense ratio (MER) or a percentage of the amount invested, can top 2.5 per cent. Within that MER, an annual commission call a trailer fee is awarded to the advisor who originally sold the fund.

Performance data over several time periods shows the average Canadian mutual fund underperforms its benchmark index once fees are taken into consideration, leaving less money invested to grow over time.

Many mutual funds consistently beat their benchmarks even after fees, but limited disclosure requirements make it difficult for average investors to find the best ones.

That lack of transparency opens the door to what is called “shadow indexing,” where actively managed portfolios bear a striking resemblance to their benchmark indices. Investors are basically paying for active management and getting a passive index fund.

INDEX-LINKED ETF PROS

In the case of index-linked ETFs, the market is your manager. 

In its purest form, passive management attempts to replicate broader indices by tracking individual holdings based on their weighting in the index and adjusting them daily as they change in value. No arbitrary decisions are made. They set it and forget it.

Unlike mutual funds, holdings and their weightings in index-linked ETFs are transparent. Price changes in S&P 500 ETFs, for example, will reflect price changes in the actual S&P 500. 

ETFs can also provide access to a diversified array of sectors and geographic regions at a fraction of the cost. The MER on basic index-linked ETFs that track major indices could be as low as one-tenth of a per cent.

INDEX-LINKED ETF CONS

While major stock market indices have always gone up over time, the market is not so good at anticipating shorter term volatility.

ETFs have no active manager to assess and steer clear of riskier holdings in an index, or determine when it’s time to sell over-valued holdings and take profits.

The success of ETFs has also moved providers to blur the line between passive and active management through “hybrid” or “smart” ETFs that apply arbitrary formulas.

As ETFs become more elaborate, fees tend to rise.