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Occasionally we are questioned about our approach of holding direct holdings and avoiding both exchange traded funds (ETFs) and mutual funds. Let’s first talk a little bit about ETFs and mutual funds to get the baseline for the discussion. Both are considered structured products meaning that they were created with a particular mandate. The main difference between ETFs and mutual funds, is most ETFs are passively managed and most mutual funds are actively managed.

There has been lots of debate about what is better, ETFs or mutual funds.

Often a person has heard that an ETF is a good option. We feel that most ETFs are better than the majority of actively trade mutual funds. An ETF is also a good option for an investor that does not have the time to appropriately select individual holdings. As a Portfolio Manager we feel picking individual holdings will result in the best outcome.

Largest ETFs and Mutual Funds

As the name suggests, exchange traded funds trade (ETF) on an exchange. 91Ô­´´s are permitted to purchase ETF investments on both the 91Ô­´´ and U.S. exchanges. Mutual funds are issued by prospectus in Canada, and you must be resident in Canada to purchase them. 91Ô­´´s are not permitted to invest in mutual funds issued outside of Canada. Below we have listed the largest ETFs in Canada and the U.S. We have also listed the largest mutual funds in Canada.

Five largest ETF investments domiciled in Canada are:

· BMO S&P 500 ETF (USD) – This fund has 504 holdings, embedded fee of 0.09 per cent

· iShares S&P/TSX 60 ETF – This fund has 60 holdings, embedded fee of 0.18 per cent

· iShares Core S&P/TSX Capped Compost ETF - This fund has 232 holdings, embedded fee of 0.06 per cent

· iShares Core S&P 500 ETF (CAD-Hedged) – This fund holds 1 ETF with 503 holdings (iShares Core S&P 500 ETF), embedded fee of 0.10 per cent

· Vanguard S&P 500 ETF– This fund has 505 of holdings, embedded fee of 0.09 per cent

Five largest ETF investments domiciled in the United States are:

· SPDR® S&P 500 ETF Trust– This fund has 503 holdings, embedded fee of 0.09 per cent

· iShares Core S&P 500 ETF– This fund has 503 holdings, embedded fee of 0.03 per cent

· Vanguard 500 Index Fund– This fund has 505 of holdings, embedded fee of 0.03 per cent

· Vanguard Total Stock Market Index Fund– This fund has 3,883 holdings, embedded fee of 0.03 per cent

· Invesco QQQ Trust– This fund has 101 holdings, embedded fee of 0.20%

Five largest equity mutual funds domiciled in Canada are:

· RBC 91Ô­´´ Dividend Fund – This fund has 82 holdings, embedded fee of 1.76 per cent

· Mawer Global Equity Fund – This fund has 62 holdings, embedded fee of 1.31 per cent

· Capital Group Global Equity Fund Canada – This fund has 202 holdings, embedded fee of 1.91 per cent

· Scotia 91Ô­´´ Dividend Fund – This fund has 47 holdings, embedded fee of 1.73 per cent

· Edgepoint Global Portfolio – This fund has 42 holdings, embedded fee of 2.09 per cent

The average number of holdings for the above ETFs is approximately 730 and the average for the above mutual funds is 87.

Annual embedded fees

As noted above, ETFs and mutual funds are both structured products, with embedded fees. The average embedded fees for the ten ETFs noted above are 0.09 per cent. This is materially lower than the five equity mutual funds noted above with an average embedded fee of 1.76 per cent.

Transactional account - costs to purchase and sell ETFs

Self-directed account

Individuals can execute ETF trades in a self-directed transaction account for relatively low commission. The commissions vary but are typically around $9.95 per trade with self-directed accounts. With a self-directed account, you are responsible for the selection of the ETF investments and the timing of when they should be bought or sold.

Full service transactional account

Wealth Advisors that recommend ETFs in a transactional account charge a commission to both purchase and sell an ETF. The commissions are approximately 2.50 per cent for the buy and 2.50 per cent for the sell. For purposes of this illustration, we will assume the ETF has a management expense ratio (MER) of 0.20 per cent per year. If we assume an ETF is purchased in a transactional account, and held for 5 years, the total fees will equal to 6.00 per cent (embedded fees of 0.20 x 5 = 1.00) + buying fee (2.50 per cent) + selling fee (2.50 per cent).

Fee-based account – Costs to purchase and sell ETFs

For purposes of this analysis, we will assume the annual fee charge by your Wealth Advisor is 1.00 per cent. We will also assume the investments are in a taxable investment account. There are no commissions for buying or selling the ETF within a fee-based account. The 1.00 per cent annual fee is considered an investment counsel fee. Assuming the same ETFs as above (held in the transactional account) the management expense ratio of 0.20 per cent per year still applies. If we assume an ETF is purchased in a fee-based account, and held for 5 years, the total fees will equal 6.00 per cent (embedded fees of 0.20 x 5 = 1.00) + (1.00 x 5 years = 5.00).

Deduction of investment counsel fees

With fee-based accounts, if a client is in the top tax bracket, the investment counsel fees (not the embedded fees) are tax deductible and 53.50 percent of the 5.00 per cent would be recovered. The net out of pocket fees would be 3.32 per cent. Commissions within a transactional account are not tax deductible as investment counsel fees. Essentially, if there is any reasonable level of activity, and you are using a Wealth Advisor to execute the ETF trades, it is best done in a fee-based account.

Transactional account - Mutual fund

Mutual funds can be bought today primarily on either a no load / no commission basis, front-end, or F-class. We recently wrote an article about another method that mutual funds used to be sold on called

deferred sales charge (DSC) that have now been banned. With front-end, a mutual fund representative may charge anywhere from 0 – 5 per cent of the initial amount invested. With no load / no commission mutual funds, there is no initial purchase costs. For purposes of this article, we will assume an investor purchases the mutual fund on a no commission basis. The only fee that the investor will pay is the embedded fee of 1.76 per cent every year (the average MER of the five largest equity mutual funds). We estimate the total embedded mutual fund fees (1.76 x 5 years) = 8.80 per cent. Unfortunately, as these fees are embedded within the mutual fund, they are not tax deductible as investment counsel fees.

Theory of diversification

The term diversification has been one of the cornerstone discussions when dealing with ways to minimize security-specific risk and reduce portfolio volatility. When we talk to clients, we will explain volatility and the level of diversification required to balance both return expectations and risk. The overall focus should be on generating the best risk adjusted return over time, not eliminating all volatility. Focusing on companies that will weather the various market cycles over time. Below we have expanded more on diversification.

Overdiversified

There are thousands of mutual funds and ETFs to choose. It is an exercise, in and of itself, to decide which fund or ETF to choose. Once you have decided on which fund you want, do you understand how much is held in each individual holding? Let’s use the SPDR® S&P 500 ETF Trust (SPY) as an example, which holds 504 United States companies. This is a market weighted ETF, which means that the larger the market capitalization of the underlying company, the greater the percentage allocated to that company. The top two holdings in SPY account for 14.49 per cent (Apple 7.14% and Microsoft 6.83%) of the fund as of June 27, 2023. If you were to choose an equal weighted ETF like Invesco S&P 500 Equal Weight ETF (RSP), you would have the same weighting in all 504 holdings. This would mean that this ETF holds approximately 0.2 per cent of each company. If we like a company, then we are comfortable holding up to a 5.0 per cent weighting in that company which is 25 times the size of the equal weighted ETF.

The Greenard Group Diversification Exercise

We are of the belief that not all companies are equal. Some are worth overweighting, and most are worth avoiding all together. If we were to list our top 200 companies, starting with our favourite company at the top going down to the 200th company, then it makes no sense for us to put an equal weight of investment dollars in the 200th company as you would the 1st company. Instead, we would invest in the top 30 to 35 companies and concentrate the investment dollars in the best quality companies.

Diversification – New Investor

My recommendation for new investors is to focus first on savings and avoiding investment mistakes. We often see younger investors too focused on the get rich quick speculative trade. If a new investor has $50,000, then buying an ETF or a well managed mutual fund is a good choice to get started. Even with an investment return of ten per cent, the account would only increase $5,000 during the year. If the focused shifted to saving funds every month, say $1,000 per month, the investment account would increase by $12,000 from the savings. Monthly savings can easily be added to an ETF or a mutual fund for diversification.

Warren Buffett’s Advice

We feel that success is largely achieved by saying no to almost every investment promoter or hot trend that is being pumped on television and social media. Warren Buffett has been quoted as saying, “The difference between successful people and really successful people is that really successful people say no to almost everything”. Warren Buffett’s personal portfolio is comprised of only five equities. Warren Buffett does not own any ETF or mutual fund investments.

Diversification – Investors with $500,000 or more

In our opinion, investors who have $500,000 or more can easily diversify with direct holdings. With the direct holdings approach, we can focus on the best quality holdings, and we are able to make sure that each holding is held in the most tax efficient account. We wrote an article The Greenard Groups Six Principles of Placement which highlights why the placement of individual securities is important in creating a tax efficient portfolio. With direct holdings you can also focus on the position size of each holding. The Greenard Group’s Growth model portfolio contains between 30 to 35 holdings. No position would be more than five per cent, unless documented in the Investment Policy Statement (IPS). In our article The model portfolio approach to investing we discuss all the benefits of the model portfolio approach to investing.

Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250.389.2138, email [email protected], or visit .