Reduce fees on index funds

"All-in-one" index funds (AIO) have become extremely popular recently as they make it dead simple to have a globally diversified portfolio that matches your needs for an affordable price. But for those interested in working a little bit you can save thousands or even tens of thousands of dollars in fees.

What is an AIO Index Fund

AIO indexs are usually combinations of many smaller index funds to provide diversification but usually they come at a premium. The index fund owner charges a fee called the "Management Expense Ratio" (MER) usually between 0.1%-0.5%. For example Vanguard has the "Vanguard All Equity" fund with an MER of 0.25%, lets look at the funds components:

VEQT FactsheetMarch 2021

VEQT is just 4 Vanguard funds combined, we could just buy those and get the same return right? Lets look at their MER:

Vanguard US Total Market Index ETF (VUN) - MER: 0.16%
Vanguard Canada All Cap Index ETF (VCN) - MER: 0.06%
Vanguard Developer All Cap ex NA Index ETF (VIU) - MER: 0.22%
Vanguard Emerging Markets All Cap Index ETF (VEE) - MER: 0.24%

All of the underlying funds within VEQT have a lower MER then VEQT itself and if we weight the MERs based on the fund allocation we see the "effective" MER:

0.16% x 0.41 + 0.06% x 0.30 + 0.22% x 0.21 + 0.24% x 0.8 = 0.149%

Benefits of Purchasing Underlying Funds:

1. Reduced MER Drag

So if you buy the underlying index funds rather then VEQT you will save over 10 basis points or 0.1%. If you save $10,000 a year for 40 years that compounds to nearly $60,000 extra:

Calculated using this calculator

That averages to $1,500 a year or $125/month for simply buying 4 index funds instead of 1. Its important to note that the MERs of the underlying funds and their proportions may change increasing/decreasing the drag relative to the AIO option.

2. Tax loss harvesting

As you begin getting into unregistered investing you may find yourself exploring "Tax loss harvesting" (TLH), this is when you sell an asset at a loss and buy back a similar but different asset. The process allows you to realize capital losses and lower your income tax while still remaining invested in the market.

For example if you held $100,000 in VEQT and your portfolio dropped 30% you could sell all your holdings and buy XEQT which provides you a globally diversified portfolio but you can claim a loss of $30,000 at tax time.

It's not ideal to sell your entire portfolio whenever you want to perform tax loss harvesting so by holding the underlying funds you can perform TLH on portions of your holdings.

3. Tax efficient account location

The RRSP, TFSA, and unregistered account are taxed differently. For example the RRSP is exempt from US witholding tax on dividends so there is an argument that you should prioritize holding US dividend paying assets within your RRSP and Canadian dividend paying assets in your TFSA or unregistered accounts.

If you hold VEQT you must have identical allocation across all your accounts but if you instead purchase the underlying funds you could prioritize VUN in your RRSP and VCN in your TFSA.

Asset location is highly debated but worth researching so you can make up your own mind. This PWL article is a great place to start.

How to purchase underlying funds easily

I use Passiv, but a manual alternative is making a spreadsheet. If you opt for the automated solution Passiv is a simple interface that connects with brokerages like Questrade and IBKR that allows you to create "portfolios" and in a single button click you can rebalance your account to align with your defined allocation.

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