Podcast 23: Ask The Spud Edition

It’s been a while since our last CCP podcast, but we’re back with an all-new episode. This time I’ve devoted the whole show to answering questions from listeners and readers.

Here are some issues we address on the podcast:

What is the likelihood of an ETF closing down, and what would be the consequences for investors if this happens?

I touched on this issue in a blog post a few years ago. It’s important to understand what happens if an ETF closes its doors, because that can certainly happen.

Usually, the reason ETFs shut down is simply that they’re unable to attract enough assets to be profitable. In that case, the provider typically issues a press release announcing that the fund will be closed on a specific date: you can sell your units on the exchange any time before that and receive their fair market value.

Remember, the value of any ETF or mutual fund is determined by its underlying holdings, and the stocks and bonds in the fund won’t be affected by its looming closure. So there is no reason to expect the fund will fall in value after it announces its pending demise.

An ETF may also close down because of a change in investment or tax law. It has occurred before, and it might happen again in the near future with the popular Horizons swap-based ETFs, as the most recent federal budget made it quite clear that it was planning to target these funds, and it is possible their structure may eventually be disallowed. Since these ETFs are so large (HXT and HXS together hold close to $3 billion), it seems likely Horizons would come up with a transition plan that won’t force investors to liquidate all of their assets.

My Couch Potato portfolio also includes a Canadian equity mutual fund that is a leftover from another investment firm. This fund is down 10%. Should I hold onto it for a bit longer, or just sell it and put the proceeds into an ETF?

We have a strong intuition that we should wait for a stock or fund to get back to even before we sell it. But this is almost always a mistake. The decision is even easier if you’re selling an expensive mutual fund and replacing it with a cheap ETF in the same asset class. I like to compare this decision to cancelling an expensive auto insurance policy and replacing it with a cheaper one that offers the same coverage. It’s almost a no-brainer.

Are there times when it doesn’t make sense to immediately sell an expensive fund and replace it with an ETF? Sure. If you hold the fund in a taxable account and it has a very large capital gain, you may not want to realize it all at once and take a huge tax hit. Another exception might be if the mutual fund has a deferred sales charge. In some cases, it could make sense to hold onto the fund a little longer and sell it gradually to keep those deferred sales charges to a minimum. (But even then, making a clean break is often a good idea.)

Through some good fortune, our portfolio will soon be in the seven figures. At what point would you consider a simple DIY index portfolio insufficient?

Those who are fortunate enough to have very large portfolios usually reach a point where they wonder whether a conventional index portfolio is still appropriate. Part of the problem is that index investing often seems unsophisticated – and I have to admit, terms like “Couch Potato” don’t help the cause.

But just because you can build an index portfolio with just one, two, or three ETFs does not mean the approach is unsophisticated. And it certainly doesn’t mean it’s inadequately diversified. Even the humble Vanguard Balanced ETF Portfolio (VBAL) includes almost 12,000 stocks and bonds from dozens of countries, all wrapped into a single product. Even an investor with a few million dollars does not need more diversification than that.

If a very wealthy investor is bent on branching out from the traditional stock and bond markets, I generally suggest they consider real estate: perhaps a rental property that can generate a reliable stream of income, and that is likely to be uncorrelated with their portfolio. Being a landlord isn’t right for everyone, but if it appeals to you, it’s almost certainly a better bet than hedge funds, or other so-called “alternative strategies” that are touted as a complement to stocks and bonds.

I don’t quite have enough money to make ETFs cost-efficient in my portfolio, so I’m using index mutual funds instead. I’m thinking about selling these once a year and making a single ETF purchase to benefit from the lower fees without paying a lot of trading commissions. What do you think?

Over the years I’ve spent a lot of time laying out the advantages of index mutual funds over ETFs, but most investors are not swayed by these arguments. They can be laser-focused on paying the lowest management fees possible to the exclusion of other concerns (I also think mutual funds still carry some stigma because of their association with high fees and underperformance).

I get a lot of questions from investors who want to use a hybrid strategy while their portfolio is too small to make ETFs cost-efficient. Usually, this involves making regular contributions to index mutual funds or savings accounts until they have enough to make an ETF trade. If you’ve been doing this successfully for a couple of years, I won’t try to talk you out of it. But if you’re a new investor, I’d suggest something that will require significantly less maintenance.

If you are confident you can manage an ETF portfolio, and you plan on making smallish monthly contributions, then look for a brokerage that offers cheap, or even free ETF trades.

Although you cannot set up a traditional automatic purchase plan with ETFs like you can with mutual funds, you can set up regular cash contributions to your brokerage account. Then you’ll need to go in once a month or so and manually place a trade to invest that cash. If you use this strategy along with a one-ETF portfolio, you’ll pay an annual management fee of about 0.20% and incur virtually no transaction costs, and you’ll never have to rebalance. In my opinion, that makes a lot more sense than trying to juggle some combination of index funds and ETFs.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.