8 Things Every Investor Should Know About Mutual Funds
Markus Muhs - Nov 21, 2016
Mutual funds – love ‘em or hate ‘em – are by far the most popular investment vehicle among Canadian retail investors. In total, Canadians hold more than $1.3 trillion in mutual funds as of July 31, 2016. This compares to around $100 billion held in ETFs, and the overall trend over the past two decades has been away from individual stocks, toward funds.
Years ago I was able to list every single fund in Canada on my fund-tracking software and I think the grand total came to around 7000 funds, but there have been so many new fund companies popping up and new fund inceptions, that the total likely exceeds 10,000 by now from over 50 different fund companies. The largest funds in Canada manage upwards of $20 billion, while there are funds out there with stated AUMs (assets under management) as low as $1 million.
When you buy a mutual fund you’re buying a basket of stocks, usually managed on a discretionary basis following a stated mandate, or in some cases set to track an index. Funds are purchased either directly from a fund company or with an investment dealer through the FundServ network. That much is generally understood by most investors, but there is a whole lot more to mutual funds that is often not fully understood or is outright ignored that I wish to highlight here.
Whether you invest in mutual funds with me, on your own, with some other advisor, or haven't invested yet but are curious; here are 8 things I think everyone should know.
1. MER & TER
These acronyms signify the cost of owning a mutual fund. A fund’s price - called net asset value (NAV) - is irrelevant in the purchasing decision - what ultimately matters are the fees.
MER: The Management Expense Ratio is what is most often quoted as your cost of owning a fund. It includes the Management Fee, which itself includes a trailing commission paid to the advisor (if applicable), and miscellaneous operating expenses. A fund’s MER represents these costs as a percentage of assets, quoted on a trailing basis (ie: over the past year, X% of a fund’s assets went towards management and operating costs).
This graph, courtesy of TD Asset Management, helps illustrate the break-down of the MER on a typical commission-based mutual fund and where the money goes to:
TER: The not so often quoted Trading Expense Ratio is an additional expense that represents the trading costs of a fund and can vary greatly from fund to fund, depending on how actively it is managed. It's a cost to be aware of but take into account that it is directly correlative with fund activity. Provided the fund management is making good decisions for you, a higher TER could represent that you're getting better value for your management fees, while a very low TER could represent a fund that's sitting on its hands while still charging you a high management fee (more on "closet indexing" in the next section).
A fund’s expenses are subtracted from the fund’s assets on a daily basis and in the long run have the effect of reducing your returns by a like amount. Most fund companies do try to deliver value for the fees you pay and all performance figures quoted by fund companies are always net of fees, so this isn’t an additional deduction from returns. To simplify: if a fund reports its performance over the past year at 8% and it has a 2% MER, then it means the underlying assets of the fund actually grew by 10% over the past year.
2. Active vs Passive fund management
When looking at the vast array of funds out there, one distinguishing factor is whether or not a fund simply tracks an index or is actively managed. The majority of mutual funds out there are actively managed – or at least they claim to be.
A problem with the overall fund industry is that many funds that are sold as actively managed (and charge fees for active management) are actually closet-indexers. Generally, you can own an index mutual funds or ETF at a much lower fee, so investors should expect truly active management for the fees they pay. A closet-index fund is kind of like buying a Ferrari with a Fiat engine.
Because we generally benchmark a fund’s performance to an appropriate index, a lot of fund managers – more afraid of underperforming the index than enticed to outperform it – purposefully seek to mostly own an index in their portfolio, with only slight deviations.
You can get a general idea of how active a fund is by doing a cursory glance at its top holdings, how similar they are to the index, as well as noting a fund’s turnover ratio (you have to dig for this information: 100% = all holdings bought and sold on average once per year, while any number less than 10% is fairly inactive). When it comes to Canadian equity funds, it’s easy to spot a closet-indexer when you see all 5 major banks in the top holdings (aren’t we paying someone to analyze and choose stocks for us?).
It's possible also to own a portfolio of good actively managed mutual funds, but by owning too many funds you can over-diversify your portfolio so that the end result is that you own an index portfolio at a managed price. You can read more about this in my blog post from last year, Diversification or Diworsification.
3. Different fund series and how funds are sold
The largest fund companies in Canada sell their funds via an alphabet soup of various fund series, and this is where the greatest confusion lies among investors. Most people are oblivious to the meanings of these different fund series, and no surprise as there often isn’t much standardization between companies. Here are a list of the types of fund series out there and how they’re usually identified in each fund company’s line-up, along with a sample MER just for cost comparison and to see how the embedded commission affects this cost:
Other series of funds not as relevant to most of us are institutional series, usually having very high minimums. These are denoted as “I-series”, or “O”, or “M” or some other letter in that range of the alphabet.
4. Corporate Class vs Trust
Mutual funds are structured as either corporations or trusts, with many funds available for purchase in either flavor. The distinction between the two is only relevant when investing in taxable accounts.
To explain the benefits of corporate class in a taxable non-registered account or holding corp I could probably write a whole blog post. Generally most people benefit from the ability to switch corporate class funds on a tax deferred basis (at least until the end of 2016, when the recent budget changes the tax treatment on this) as well as the minimization and deferral of most other taxable income to a later date.
To determine if corporate class funds are appropriate in your particular situation, contact me.
5. Distributions and Return of Capital
Most funds have to pay distributions at some point in order to shift taxable income from the trust or corporation’s hands into the hands of the investor. Usually these distributions are paid in December, but a fund might not pay a distribution in a given year if it did very little trading throughout the year or had sufficient capital losses to offset gains.
When a distribution is paid the NAV of the fund is reduced by an amount equal to the distribution. As many investors set their funds to reinvest all distributions, these distributions have the effect of increasing the base cost of a fund. This is why it’s usually difficult to estimate a fund’s return by comparing its base cost with its market value. For example, if you invest $10,000 in a fund at the beginning of the year, and it goes up 10% but pays a 10% distribution, reinvested: in January the following year you have a fund with a base cost of $11,000 and a market value of $11,000.
Some funds investing predominantly in interest or dividend paying investments pay distributions more regularly throughout the year. Monthly income funds (balanced funds that are split between bonds and dividend paying stocks) are some of the most popular funds at many fund companies.
Often times, both with monthly income funds and T-series funds, monthly distributions may consist largely (or entirely) of “return of capital” (RoC). RoC isn’t an actual investment return, it’s a distribution by the fund made up of your own capital being returned to you. In certain tax circumstances this can be beneficial, should someone want high after-tax distributions from their investments today but a higher tax bill in the distant future.
Unless your goal is to receive a high income stream from your investments, the rate of distribution should be of no concern. I make this point because there often is confusion around this - sometimes propagated by sales reps at banks - that a high distribution equals a superior return.
7. What is CRM2 and what does it mean to you?
The Investment Advice industry in Canada has been going through some fairly significant changes over the past 5 or so years, and things are expected to continue to change into the future. CRM2 is the second phase of the “Client Relationship Model” intended to bring greater transparency and fairness to the investment industry.
CRM2 affects more than just mutual fund investing but rather than go through the whole history of all the phases of CRM2, below are how the changes affect you as a mutual fund investor:
- As of July 2014 all advisors have been required to fully disclose all charges involved in a trade prior to the transaction. Where mutual funds are concerned, investors were mailed a Fund Facts document after the fact including all the details, with the usual rights to cancel the purchase if they felt erroneous information was provided by the advisor.
- As of May of 2016 advisors needed to start providing the Fund Facts document at the time of purchase of a fund, either in person or by e-mail, and should review the various details. More on the Fund Facts below.
- In January 2017 most investment dealers will begin mailing additional annual statements detailing ongoing compensation received by the dealer from mutual fund companies (trailing commissions) as well as detailing what, if any, deferred sales charges might apply to particular funds. Dealers will also start providing standardized investment performance.
In the past it seemed that investors were fairly oblivious to the costs in owning mutual funds (what that MER equates to in dollars and cents) and most of all what gets paid to the advisor and/or bank branches. I've had this conversation numerous times with prospective clients, who later became clients once they understood how it all worked:
"Do you know what you're paying annually for your current advisor's service and are you getting value for your fees?"
"I pay $125 per year for my RRSP."
The aforementioned annual fee statements coming out in January could come as a shock to a lot of people. Many might be surprised to find they're paying thousand of dollars per year to an advisor who hasn't contacted them in years, or that even a small mutual fund portfolio sitting at the bank that they manage themselves is costing them hundreds of dollars per year.
8. The Fund Facts Document
Lastly, I just want to emphasize the importance of the Fund Facts Document. CRM2 in its latest phase puts the Fund Facts document front and center on every mutual fund purchase decision, and if you have purchased mutual funds any time in the last couple of years you've likely seen these documents.
Prior to the Fund Facts, the main information document that regulators required to be delivered to investors after the purchase of a mutual fund was the fund's simplified prospectus. Generally, these documents weren't that simplified and included an overkill of information, much of it not completely relevant to the investor or otherwise just boring. Back when I purchased my very first mutual funds when I was 18 I was probably part of a tiny minority who read the prospectuses cover to cover.
The challenge the industry faced, in becoming more transparent, is not just providing information to investors, but also providing it in a way that is digestible. The Fund Facts provide all the relevant information in a 2 to 4-page document that is more or less standardized from fund company to fund company and mostly devoid of any marketing (except for the fund company logo and colors) and legalese.
I cannot stress more how important it is for every investor in a mutual fund to read and understand the full Fund Facts document of any new fund they purchase. It isn't a lot to read, and the information included is almost 100% relevant to you. Each Fund Facts contains the following sections:
- Quickfacts: Basic info on the fund, including who manages it, cost (MER), and minimum investment amounts
- What does the fund invest in? Obviously you want to know this.
- How risky is it? Including a general "risk rating"
- How has the fund performed? Includes calendar year returns and best and worst 3 months.
- Who is this fund for?
- How much does it cost? This is the single most important section of the document, detailing the fund expenses (including often ignored TER), what costs an advisor might add, along with detailed information about how the advisor is compensated (from trailing commission to front end or back end commissions, if applicable).
- What if I change my mind? Outlines what your rights are and how you can cancel your purchase or withdraw from the fund if any of the information in the Fund Facts document goes contrary to what you understood of the fund.
When an advisor is recommending a switch from one fund to another, it would also be useful for the investor to know the details of the fund being switched out of, for comparison purposes. It isn't yet a requirement though for advisors to provide this information. Often I've witnessed (third hand) an advisor recommending a switch from one fund to another for the sole purpose of bumping up their trailing commission (a good reason to go to a fee-based advisor, so that such a conflict of interest can be avoided entirely).
For example: Fund A and B are both balanced income funds, both investing predominantly in bonds but with slightly different mixtures of bonds to stocks. Fund A is a bit more conservative, has a 1.75% MER and a 0.75% trailing commission. Fund B has a slightly higher allocation to stocks and has a 2.25% MER and a 1.25% trailing commission. When the switch is recommended, the advisor only needs to provide a Fund Facts of Fund B, so the investor isn't aware of the fact that the end result is a 0.5% increase in MER and like increase in the advisor's compensation.
By no means do I want to give the impression here that mutual funds are bad investments. They are an excellent way for those of us without millions of dollars to get access to professional investment management and diversification. As mentioned, there is an enormous selection of funds out there; many companies emphasizing the minimization of costs, the creation of value in terms of truly active management, and steering advisors away from commission-laden products. An astute advisor - one who isn't employed by or affiliated with a single mutual fund company - can help you build a portfolio that is both properly diversified and cost-efficient.
I have the tools available to me to quickly and easily evaluate any mutual fund/stock/ETF portfolio and provide a detailed summary of what you're invested in and your total costs. Please contact me if you would like a complimentary portfolio analysis or have any questions on what you have read here.