When mutual funds are a good idea

Shannon Dalziel, a fee-based investment adviser at PWL Capital in Toronto, knows all too well that mutual funds have a terrible reputation. It’s not uncommon for her clients to balk at the very notion of using them—and it’s easy to understand why. Canada’s mutual fund industry is mired in a tradition of outrageous fees, hidden sales charges, and self-interested salespeople who have eroded the public’s trust. So it’s little wonder that exchange-traded funds—which usually have much lower fees—are often perceived as the only investment tool for savvy savers. “What many people don’t seem to realize is the structure of mutual funds is perfectly sound,” Dalziel says. “When used correctly, mutual funds can be very appropriate for certain types of investors.” There’s no question ETFs are one of the best things to happen to Canadian investors in decades, but they’re not for everyone. For starters, you normally pay commissions to buy and sell them, which makes them unsuitable for small accounts (you typically need at least $50,000 to make them cost-effective) or those who make preauthorized monthly or biweekly contributions. ETFs are also fairly complicated for the novice, since they’re bought and sold like stocks through a discount brokerage. Not everyone is comfortable managing their own portfolios this way, and while you can enlist professional help and buy ETFs through full-service brokers, many financial advisers are not licensed to sell ETFs. Those who are often work only with wealthy clients. Mutual funds, on the other hand, are easy to buy through banks, fund companies, independent advisers or discount brokerages. There are usually no commissions when you set up automatic contributions, making them ideal for regular savers. Actively managed mutual funds also give investors the opportunity to earn market-beating returns and the peace of mind that comes from knowing a professional is managing your portfolio during times of market volatility. The key, as Dalziel points out, is learning to use mutual funds correctly, and to avoid their many pitfalls. Let MoneySense show you how.

Avoid high-fee funds

The biggest problem with mutual funds in Canada is simple: they’re way too expensive. A 2013 Morningstar report ranked Canada’s mutual fund fees the highest in the world: they routinely carry management expense ratios (MERs) between 2% to 3%. Most of that cost covers investment management and operating expenses for the fund, while about 1% goes to your adviser in exchange for ongoing service. (This part of the MER is called a “trailing commission” or “trailer.”) It’s a myth that funds with higher MERs offer better management. On the contrary, funds with the highest fees tend to be the worst performers over the long term. In a recent report, Morningstar director of research Russel Kinnel was explicit on this point: “In every single time period and data point tested, low-cost funds beat high-cost funds.” Even a 2% annual fee—which may appear benign—will exact a hefty toll over time. A modest $50,000 portfolio would incur $1,000 in fees every year. If we assume a balanced portfolio will return 6% annually before costs, a 2% MER will eat almost a third of your potential returns over a 20-year time horizon; at the 30-year mark, you’ll lose 45%. That said, investors just starting out don’t need to be overly concerned with fund fees, says Dan Hallett, vice-president and director at HighView Financial Group. If you have $10,000 to invest, for example, a 2% fee works out to $200 a year, which may be worth it. “The real value is the behaviour you’re learning by developing saving habits early on.” At the other end of the spectrum, if you have a large portfolio, negotiating lower fees should be a priority, says personal financial expert and former adviser Preet Banerjee. At the big banks, $200,000 to $400,000 will typically get you kicked up to the wealth management division, where you should get access to a wider variety of funds at lower fees. “Once you get to that level of assets, you’re probably looking at a 0.50% to 0.75% reduction compared with in-house fund portfolios at the branch level,” Banerjee says. You should also avoid mutual fund commissions, or “loads.” Front-end loads, often associated with A-series funds (see “What do the letters mean” below for an explanation), can be up to 5% and are deducted from your original contribution. Back-end loads, often associated with B-series funds, apply when you sell: they’re typically 6% in the first year, dropping one percentage point each year you hold the fund. Back-end loads—also known as deferred sales charges, or DSC—may sound appealing because they avoid upfront costs. But DSCs may handcuff you to underperforming funds for many years. Dave Paterson, director of research and investment funds for D.A. Paterson & Associates, warns investors to avoid advisers pushing these types of funds: “If they recommend DSCs, walk out the front door—or at least demand front-end,” he says, adding these may be negotiable.

Get what you’re paying for

Mutual fund fees may be worth it if they include genuinely good advice, says Norm Rothery of StingyInvestor.com. The problem is, many advisers charge high fees and do little more than pick funds. “That’s unfortunate, because where advisers add the most value is the less sexy things like taxes, insurance or making sure your will is up to date,” Rothery says. “You don’t want to pay for things you’re not getting.” Even advisers who simply pick funds don’t necessarily do a good job of building portfolios. Overdiversification is a common problem, Paterson says. A classic balanced portfolio of 40% bonds and 60% equities shouldn’t require more than 10 different products, he says. But some advisers go too far. “There’s nothing wrong with adding some emerging markets, but if you’ve got 20 different funds, be worried. That’s called deworsification.” Rudy Luukko, investment funds editor for Morningstar Canada, says advisers should draw up a financial plan based on each client’s goals rather than using a cookie-cutter approach. “Investment objectives are not determined simply by one’s age or level of income,” he stresses. Your adviser should also make sure your funds are in the most tax-efficient accounts, particularly if you’ve saved up a sizeable retirement nest egg. If you’re holding bond funds in non-registered accounts and Canadian equity funds in your RRSP, for example, you’re paying too much tax. Retirees also need help drawing down portfolios in a tax-efficient way. “If advisers aren’t doing those types of things, they’re being overpaid,” Luukko says. And if you don’t require these types of services in the first place, you probably don’t need a full-service adviser. No one’s arguing advisers should work for free. But a long-standing problem is “embedded compensation.” Trailing commissions put advisers in a potential conflict of interest: they have an incentive to sell funds that pay them the highest commissions rather than the funds most appropriate for your portfolio. That’s why investors with large accounts may want to veer away from commission-based dealers altogether and consider hiring a fee-based adviser. A fee-based adviser may still use mutual funds, but they will be F-series, which have no trailing commissions. Because these professionals are paid directly and more transparently by clients, they’re more likely to give you unbiased recommendations. Be aware there’s a distinction between fee-based advisers who manage your portfolio and those offering à la carte financial planning. If you’re looking for someone to recommend specific funds and manage the portfolio for you, expect to pay an annual fee based on the size of your account. However, fee-only financial planners typically bill by the hour or by the project: expect to pay $150 to $250 per hour for advice, or a few thousand dollars for a comprehensive financial plan. The key difference is many planners are not licensed to sell investments, recommend specific mutual funds, or manage your portfolio. It’s worth noting some fee-based investment advisers receive 100% of their income from clients, while others may also receive commissions from fund and insurance companies.

Has your fund hugged an index lately?

High fees aren’t the only thing that can sabotage your mutual fund returns, says Dave Paterson. You should also be on the lookout for “index huggers.” These are actively managed funds so closely resembling their index benchmarks that they offer no chance at market-beating returns: investors wind up getting what is effectively an index fund, with a fee that can be 10 or 15 times higher. Unfortunately, this practice is rampant in Canada, because our market has so few large, frequently traded stocks. The University of Notre Dame’s Martijn Cremers recently analyzed our country’s largest mutual funds and found only 10% were highly active, 30% were moderately active, and 60% simply mirrored their index benchmark. The situation is very different in the U.S., where managers have far more investment choices: Cremers’ most recent data found only 15% of actively managed funds were index huggers. If you’re paying 2% or more for a Canadian equity fund that just holds the big banks and energy producers that dominate index funds, your chance of beating the market is virtually zero. That’s why investors who want the potential for index-beating returns should look for funds that are truly actively managed. A simple way to do this is to look up its Morningstar Industry Sector Concentration (ISC) score, a measure of how a fund’s holdings compare with the overall market in terms of its allocation to financials, energy, consumer retailers, utilities, and the like. If you’re using actively managed mutual funds, it’s reasonable to expect market-beating returns—or at least superior risk-adjusted returns—over the medium to long term. Your adviser should provide you with your personal rate of return on a yearly basis. Those returns should be compared with an appropriate benchmark that mirrors your asset allocation, says Banerjee. So if you have a portfolio with 20% Canadian equities, 20% U.S. equities, 20% international equities and 40% Canadian bonds, compare its performance to a similarly weighted Couch Potato portfolio of cheap ETFs. If your active funds consistently underperform comparable index funds, you have to ask whether the fund managers are earning their fees.

Buy direct

If you’re capable of managing your own portfolio you can avoid advisers altogether and open an online account directly with a low-fee mutual fund provider such as Steadyhand, Mawer, or Phillips, Hager & North. By forgoing planning services, investors can reduce costs to about 1% for bond funds and 1.5% for equity funds, or even less. Preet Banerjee is a big fan of Steadyhand’s model, particularly for fledgling investors, because you can open an account with as little as $10,000. Its Founders Fund is an all-in-one balanced portfolio with a target mix of 60% equities and 40% fixed income and a 1.34% MER. “That’s a pretty good average for active management,” says Banerjee. Steadyhand even offers fee reductions based on the size of your account and length of time you hold the funds. At Phillips, Hager & North, a minimum investment of $25,000 gives you access to the PH&N Balanced Fund, with an MER of 0.90%. If you have $50,000, look to the Mawer Balanced Fund, with its enviable track record and a price tag of just 0.98%. (Direct-sold Mawer funds are not available in Quebec and eastern Canada.) Dan Hallett says these balanced funds provide excellent value. In addition to their low fees, they are broadly diversified and have a long-term focus with low turnover, meaning they don’t chase what’s hot. Anyone seeking an easy, cheap investment solution could stick with one of these balanced funds until their portfolio reaches $500,000, Hallett says. Once you reach that level of wealth, he says, you may want to seek more personalized active management.

Assemble it yourself

Do-it-yourself investors can reduce their fund costs even further by opening an account with a discount brokerage. This has a couple of advantages, says Hallett. First, the minimum investment is smaller (often $5,000 per fund), and second, you’ll have access to a wider array of funds. One trap to watch for: A-series funds have trailers intended for advisers. But if you buy them through a discount brokerage (which cannot give advice) you’re forced to pay for a service you’re not receiving. D-series funds, which have substantially reduced trailing commissions, are a better option for those using discount brokerages. Unfortunately, only a handful of fund companies offer these, and some D-series funds carry front-end commissions. (F-series, designed for fee-based advisers, are generally not available through discount brokerages.) If the process of picking funds seems daunting, there are many free online resource services that can help. Morningstar (www.morningstar.ca) and Globe Investor (www.theglobeandmail.com/globe-investor) are good places to start. To complete your due diligence, visit SEDAR (www.sedar.com) for access to all Canadian mutual fund filings, including annual reports, prospectuses, financial statements, press releases and continuous disclosure documents.

Stick to a strategy

Investors tend to focus on products, but whether you use mutual funds or ETFs is less important than ensuring you have a well-diversified, low-cost portfolio and a strategy you’ll stick with over the long haul. “Conviction is one of the most important things in an investment portfolio,” says Banerjee. “Both index ETFs and actively managed funds will go up and down. Switching from strategy to strategy is what kills people’s returns.” For instance, those who had a balanced portfolio before the 2008–09 crisis would have more money today if they had simply stuck to their plan and rebalanced along the way. “But most people didn’t believe that and did the opposite,” says Banerjee. “That’s how all these great plans and these great investment portfolios get undone.”

What do the letters mean?

Many mutual funds are offered in various classes or series, each with a different fee structure. Here are the most common types: A-series funds include a trailing commission (often 1%) paid to your adviser or dealer. Some also include a front-end load, a commission taken off your initial investment. B-series funds also include a trailing commission and have a back-end load or deferred sales charge (DSC) that applies when you sell. D-series funds are designed for do-it-yourself investors and include a lower trailing commission (often 0.25%) than A-series funds. F-series funds are intended for fee-based advisers and carry no trailing commission. (Your adviser will add his or her fee separately.) They are generally not available through discount brokerages.

All-in-one fund solutions

No-load, low-fee balanced funds make investing easy: you can keep all of your long-term savings in a single fund. The following suggestions have relatively low MERs and excellent track records. These funds focus on long-term growth and are perfect for investors with moderate risk tolerance: about 60% of the holdings are a diversified mix of Canadian, U.S. and international equities, with the remaining 40% in bonds and cash. These balanced funds can be purchased directly from the fund company (minimums will apply) or through most discount brokerages.