ETF vs. mutual fund in Canada | Where to place your investment dollars

ETFs offer several distinct advantages over mutual funds, making them a popular choice for both beginners and experienced investors:

1. 1 Lower fees: One of the standout benefits of ETFs is their lower fees. Many ETFs are passively managed, which helps reduce costs, unlike the active management often required for mutual funds.
2. 2 Tax efficiency: ETFs tend to be more tax-efficient due to their structure. Because ETFs are traded on exchanges like stocks, they are less likely to trigger capital gains taxes until you sell your shares. In contrast, mutual funds regularly buy and sell assets within the fund, often resulting in taxable capital gains for investors.
3. 3 Intraday trading flexibility: ETFs are traded throughout the day, offering real-time pricing. This allows investors to react quickly to market changes, which is particularly useful for day traders or those who like to manage their portfolios more actively. Mutual funds, however, only trade at the end of the day based on the Net Asset Value (NAV).
4. 4 Transparency: ETFs often provide greater transparency, with many disclosing their full holdings on a daily basis. Investors can see exactly what they are buying into, while mutual funds may only report their holdings quarterly.
5. 5 Diversification: Like mutual funds, ETFs offer instant diversification by holding a broad array of assets. Whether you’re investing in a sector, commodity, or market index, ETFs allow you to access diversified portfolios without the need to buy individual stocks or bonds.

While ETFs have many advantages, mutual funds offer their own set of benefits that appeal to certain types of investors:

1. 1 Active management: Mutual funds often come with professional management, which can be appealing if you prefer to leave your investments in the hands of experienced professionals. Fund managers actively adjust the portfolio based on market conditions, potentially outperforming passive index strategies.
2. 2 Automatic reinvestment: Mutual funds offer the convenience of automatic reinvestment for dividends and distributions, which helps grow your investment over time without the need for manual intervention. In contrast, ETFs typically require you to reinvest distributions manually unless your broker offers an automatic reinvestment program.
3. 3 No trading requirements: Unlike ETFs, which require you to have a brokerage account and trade during market hours, mutual funds are simpler to manage. They don’t require daily monitoring, making them ideal for investors who prefer a “set it and forget it” approach.
4. 4 Variety of fund types: Mutual funds offer a wider variety of fund types, including bond funds, equity funds, balanced fund and target-date funds, catering to different investment goals and risk profiles.
5. 5 Low entry costs: Many mutual funds allow for low minimum investments, making them accessible for new investors who may not have significant capital upfront. ETFs, though accessible, still require investors to purchase at least one share, which may be costly depending on the ETF price.

Costs are a critical factor when choosing between ETFs and mutual funds. Let’s compare the cost of buying two popular, similar ETFs and mutual funds in Canada.

For this comparison, we’ll look at iShares Core S&P/TSX Capped Composite Index ETF (XIC)¹, a popular ETF tracking the Canadian stock market, and RBC Canadian Equity Fund² , a comparable mutual fund.

ETF (XIC):

• MER: 0.06%
• Trading commission: $4.95 to $9.95 (depending on your platform)
• No minimum investment

Mutual fund (RBC Canadian Equity Fund):

• MER: 2.16%
• No trading commissions (if bought directly through RBC)
• Minimum investment: $500

Winner: ETFs come out on top in terms of cost efficiency due to lower MERs and the absence of ongoing fees, like trailing commissions. Mutual funds often carry higher fees due to active management, which can significantly eat into long-term returns.

To truly understand how fees affect your investments over time, I recommend using an interactive fee impact calculator³ to see how much you could save by choosing lower-fee investment options.

When looking at fees, the Management Expense Ratio (MER) is just the beginning. Let’s dive into other fees that can affect your overall investment costs:

• ETFs: ETFs generally have lower MERs due to their passive nature, and trading commissions may apply each time you buy or sell shares. These fees depend on your brokerage platform, but many now offer commission-free ETF trades (we break these down later)
• Mutual funds: In addition to MERs, mutual fund fees may include charge sales loads or redemption fees, particularly if sold within a certain period. Many also have trailing commissions (recently removed for self-directed accounts), which are ongoing fees paid to advisors

Winner: ETFs have the edge with lower overall fees, particularly for cost-conscious investors looking for efficient, passive investment vehicles.

Related Article: Management Fee vs. MER

Performance is where things get interesting. ETFs generally aim to track the performance of a particular index, such as the S&P/TSX Composite Index⁴ or S&P 500, meaning their returns are closely aligned with market averages. 

Mutual funds, on the other hand, have the potential to outperform the market, thanks to active management.

Let’s compare the performance of two similar funds over a five-year period:

• ETF (XIC): Tracks the S&P/TSX Composite Index and provides returns that mirror the overall Canadian market. Over the past five years, it delivered an average annual return of around 7%, with lower fees contributing to a more consistent net return
• Mutual fund (RBC Canadian Equity Fund): Actively managed, this fund seeks to outperform the market. It posted an average annual return of around 6.5% over the same period, but with significantly higher fees (MER of 2.16%), the net return for investors ends up being lower than the ETF’s return

If we dive even deeper into the long-term impact of fees on investment returns and assume an initial investment of $10,000, the difference in MER between an ETF with 0.06% and a mutual fund with 2.16% could result in a discrepancy of nearly $15,000 in potential earnings over 20 years. 

Long story short, it's crucial to consider fees as a central factor in your investment strategy.

Winner: ETFs win on net performance, especially over the long term. While mutual funds may outperform in certain periods, the higher fees can erode gains, making ETFs a more cost-effective choice for passive investors.

Long-term investors often prioritize factors like fees, tax efficiency and potential growth when choosing between ETFs and mutual funds.

1. 1 ETFs for the long-term: With lower MERs and greater tax efficiency, ETFs are well-suited for long-term, buy-and-hold strategies. Since they generally track an index, they provide steady returns that grow with the market. The ability to avoid capital gains taxes until you sell shares makes them a tax-friendly option for long-term investors.
2. 2 Mutual funds for the long-term: Mutual funds offer the advantage of professional management, which could result in higher returns during market downturns. Additionally, they provide the convenience of automatic reinvestment for dividends and capital gains, helping your investments grow without manual effort. However, the higher fees and frequent trading within the fund make them less tax-efficient than ETFs.

Winner: ETFs are generally more suitable for long-term investors due to their lower fees and tax efficiency. Mutual funds may offer the advantage of active management, but over time, the higher fees can outweigh the potential benefits.

Risk is a key consideration for every investor, and ETFs and mutual funds offer different risk profiles depending on how they are managed.

1. 1 ETF risk: Because ETFs track market indexes, they are exposed to the same volatility as the broader market. If the market drops, so will the ETF’s value. However, ETFs offer diversification, which helps reduce the impact of individual stock performance on your portfolio.
2. 2 Mutual fund risk: Mutual funds carry both market risk and management risk. While active management can help navigate downturns, it also introduces the possibility of poor decision-making by fund managers. With that being said, mutual funds offer a range of risk profiles, from conservative bond funds to aggressive equity funds, allowing investors to choose a fund that matches their risk tolerance.

Winner: It’s a tie. Both ETFs and mutual funds can be tailored to match an investor’s risk tolerance. If you prefer passive investment with market-mirroring risks, ETFs are the way to go. If you value the potential for active management to mitigate risk, a mutual fund may be a better fit.

Tax efficiency is another major factor when choosing between ETFs and mutual funds, especially in taxable accounts.

1. 1 ETF tax efficiency: ETFs are generally more tax-efficient because of their structure. You only pay capital gains taxes when you sell your shares, not when the ETF buys or sells individual assets within the fund. This means fewer taxable events and lower tax bills, especially for long-term investors.
2. 2 Mutual fund tax efficiency: Mutual funds tend to be less tax-efficient because they regularly buy and sell assets within the fund, creating taxable events even if you don’t sell your shares. If the mutual fund sells a stock at a gain, you could be hit with a capital gains tax, even if you didn’t personally sell anything.

Winner: ETFs are more tax-efficient, making them a better choice for investors who want to minimize taxes on their investments.