Mutual Funds: Performance is Relative

Investment returns are difficult to assess in isolation.

What does it mean if an asset has an annual return of 10%? Is it good, bad, or average?

To answer that, results must always be placed in context to be of any informative value.

That brings us to relative performance. We looked at this concept a while back in Assessing Investment Returns.

For numbers to make sense, they always need to be compared to something relevant.

Historic Performance

Depending on the jurisdiction, funds may be required to present performance data for multiple periods. For example: year-to-date; 1 year; 3 years; 5 years; 10 years; since inception.

Do not be mesmerized by year-to-date or the latest one year returns. Anybody can experience success in the short-run.

Luck can play a big role. Also, management trickery can be used to make current year returns look good. We will look at common fund manipulations later.

Of course, luck and manipulation can go both ways. They can also hurt results.

When reviewing, you must go back farther in time than one year returns. The longer the return data, the less chance that luck or portfolio manipulations will distort true performance.

To illustrate throughout this post, we will use a fictional mutual fund, ABC Canadian Equity Small-Cap Fund (ABC). Let us assume ABC had returns of 12% for 1 year, 10% annually over 3 years, and 11% annually over 5 years.

In comparing historic results, that suggests a consistency in fund returns. Consistency tends to be useful, though right now we do not know if those level of returns are good or bad. But it is a start.

However, if ABC returned 45% over 1 year, but still 10% annually over 3 years and 11% annually over 5 years, it suggests potential issues. This is a large variability of returns between years. Not to mention that the 1 year results may skew the 3 and 5 year data.

You need to determine why there was this volatility. There could be many reasons for the high variance. Perhaps performance reflected changes in the economy or markets as a whole. It may suggest a modification in investment tactics or a change in fund management. Perhaps the fund moved to increase its portfolio risk over previous periods.

When there is a large change in returns, you need to determine why. There might be ramifications for future results.

Bear in mind that past performance is no guarantee of future returns.

Past performance may provide clues as to future results. But, on its own, it is no guarantee of continued success.

Risk-Adjusted Returns

In assessing fund returns, compare performance against the level of risk within the fund.

You can compare the fund performance against zero return, the rate of inflation, or the so-called risk-free rate of return (that is, the return on an investment that has no risk).

I think most of us can agree that it is important for investments to provide positive returns. More difficult is agreeing how much above that base level – 0% nominal or real rate or the risk-free rate of return – the excess return should be.

One tool is to compare the investment risk for the category of your fund to other asset classes or investment styles with similar risk-return profiles. Or to adjust your return expectations for different risk levels.

For example, I would expect over the mid to long-term, riskier equity funds should outperform money market funds or other low risk investments such as term deposits or treasury bills. Remember that as risk increases, so should the expected returns.

A fund of US government bonds should have less risk than a fund composed of bonds from developing countries or a fund with bonds from distressed companies. Because of the greater risk, I would expect the funds from the developing countries or distressed companies to have higher long-term returns than a US government bond fund. But higher short term volatility as well.

In general, the riskier the asset, the higher the expected return should. But what the exact risk premium should be is up to the individual investor.

ABC earned 11% annually over 5 years. Perhaps very low risk money market funds generated 3% annually over the same 5 years. For some investors the trade-off between equity risk and expected returns is warranted. Other investors will prefer the safety of the money market funds, rather than the potential extra return from the equity. Other investors may desire riskier assets such as venture capital to seek out even greater returns.

Comparing fund performance against assets of higher or lower risk gives some comfort as to the expected risk-return trade-off.

This has some use for analytical purposes, but it does not assist in choosing a specific fund to invest in. Not to mention that assessing risk premiums between different asset classes or subclasses can be difficult. A bit of an apples to oranges comparison.

What we want is apples to apples. For that, you need to look at a fund’s direct competition.

Peer Group Returns

In comparing funds for possible investment, historic returns within the fund alone do not mean much.

What does it really tell me to know in isolation that ABC had a 1 year return of 12% and a 5 year annual return of 11%?

Not a lot.

We can compare the risk-return of ABC to other assets. Perhaps the 5 year annual return for U.S. large cap stocks averaged 9%. Is that good relative to ABC’s performance? Some investors may say yes, others no. Some have no idea. Hard to tell because U.S. large cap stocks differ in many ways from ABC’s small cap Canadian holdings. Apples to oranges.

However, a fund’s peer group is made up of the funds with the same investment style. Apples to apples. From our example, all Canadian equity small-cap funds would be the appropriate peer group for ABC. Now we can start better assessing ABC’s performance.

If the average Canadian equity small-cap mutual fund had a 5 year 8% annual return, 11% from ABC appears strong.

Do not stop there though. Averages can often be misleading.

You should also look at the relative ranking of ABC within its peer group.

Perhaps 10% of the peer group had 5 year annual returns exceeding 20%. Another 20% had returns greater than 15%, and another 20% had returns higher than 12%.

ABC had better 5 year annual returns than the average for the entire peer group. But when looking within the peer group, at least half of the funds outperformed ABC over the 5 year period. Seeing that, I might want to consider the funds that exceeded 20% return over ABC.

When determining which funds to invest in, comparison to a fund’s peers is very important.

And like with historic returns, the longer the comparative periods, the better the analysis.

Benchmark Returns

Another excellent way to assess performance is to compare it against a benchmark return.

Benchmarks can be anything. However, in practice, broad indices are used that try to most closely reflect the investment style of the fund.

An appropriate benchmark for ABC might be the MSCI Canada Small Cap index. The MSCI index tracks smaller capitalized Canadian companies. This is preferable to the better known S&P/TSX Composite Index. Why? Because the TSX Composite Index is weighted by market capitalization, so it has a large-cap bias.

To the extent possible, always try to compare apples to apples with benchmarks. This is especially true for the many investors who compare their portfolios to the Dow Jones Industrial Average. A very popular index in the media, but it only tracks 30 extremely large U.S. listed companies. Most investors have portfolios of a much different composition.

For many funds, you do not need to create your own benchmark. The fund itself determines a benchmark for comparison and discloses the benchmark to investors.

Always check to ensure that a fund’s benchmark is truly representative of the fund’s investment style. In our example, comparing the performance of ABC to 90 day U.S. Treasury Bills or 30 year Euro bonds makes little sense.

There may also be a standard benchmark for the peer group within which your fund sits. That way it is easy to compare funds within a specific peer group to each other and the same benchmark.

A major problem with comparing fund performance to an index is that the fund has operating expenses. An index does not. The greater a fund’s total expense ratio, the larger the performance deficit versus the benchmark. As a result, funds start at an immediate disadvantage when trying to beat their benchmarks.

Consider an index fund that mirrors the S&P 500. To the extent that it can duplicate the index, the gross performance of the fund should match the performance of the S&P 500. Perhaps the gross returns for both were 10% last year. But the fund also has a 2.0% total expense ratio. So, on a net return basis, the index fund under-performed the benchmark by 20% (10% for the S&P 500 versus 8% net return for the index fund).

Another thing to watch with benchmarks is that the fund sticks with its chosen benchmark. Should the fund change its investment style, it may be appropriate to modify its benchmark. But if it changes its benchmark simply to hide under-performance or in trying to make itself look better, be wary.

Summary

Past performance is not an indication of future investment success.

It may show a consistency of performance, especially if you look at longer term results. And it may indicate potential problems or changes within a fund.

While historic returns have some value, you should compare a fund’s returns against other asset classes of differing risk. You want to ensure that the risk premium on your asset is reasonable given other potential investments.

Even more important, always compare a fund’s performance against its peers and relevant benchmarks.

In assessing peers, look at both absolute returns and the fund’s ranking within the peer group.

In reviewing against a benchmark, ensure the chosen benchmark is appropriate for the fund’s investment style.

Mutual Funds: Performance

Previously, we reviewed mutual fund transaction and operating costs. Both have substantial impact on investor wealth accumulation. Another more obvious component of asset growth is mutual fund performance.

As we have covered investment return considerations a while back, this will be brief. Though a reread of the linked posts may be worthwhile.

Total Returns not Change in Net Asset Value

Always use total return when calculating or assessing fund performance.

Total return reflects the period change in the net asset value of the fund plus any income or capital distributions made to shareholders during the period.

It is important not to forget distributions or your results may seem poor.

Annualized not Cumulative Returns

When reviewing returns for periods greater than one year, the performance figures should be on an annualized, not cumulative, basis.

Annualized returns allow for better comparisons between periods.

Net not Gross Returns

Know what is included in the performance data you analyze.

When assessing fund performance, make sure that you review net returns and not gross.

Net returns are those that factor in fund total expenses when determining performance. As every dollar of expense negatively impacts your own return, you want to ensure that all the costs are factored in to the return calculation.

There is a trend to ensure that net returns are reported, but there are still some differences between regulatory jurisdictions in reporting requirements.

My Fund’s 5 Year Annualized Return was 11%

A fund’s performance is important when assessing potential investments and monitoring existing ones.

But knowing a fund’s return in isolation does not provide much information content.

If my fund returned 11% annually over 5 years, is that good?

Maybe. Maybe not.

To determine the answer we always need to put returns into proper context.

We shall consider relative performance in our next post.

Mutual Funds: Operating Costs

Besides potential sales charges and brokers’ commissions, you incur ongoing fees for the costs associated with operating a mutual fund. These costs can differ significantly between funds and should be reviewed carefully before investing.

Assessing a mutual fund’s cost structure is key to investing success.

Minimizing Fund Expenses is Vital to Investment Success

Capital spent on items other than the actual investment is money that does not earn a return and compound on your behalf. As a fund’s expenses fall into this non-income generating category, they are extremely important to consider when investing in mutual funds.

For example, two global equity mutual funds each had a gross return of 10% last year. Fatcat Global Equity Fund had operating expenses of 5% Assets Under Management (AUM). Lean Global Equity Fund had operating expenses of 2%.

On a net basis, instead of identical returns, Lean had superior performance. If the same returns and expenses continue in the future, over time there will be a significant difference in shareholder wealth.

Perhaps you invested $10,000 in each fund. In rough calculations (ignoring taxes, distributions, assuming annual reinvestments, same annual returns and expenses, etc.), at the end of 5 years your Fatcat investment would be worth roughly $12,750 and Lean worth $14,700. At the end of 10 years, Fatcat would be worth $16,300 and Lean $21,600. After 20 years, Fatcat would be worth $26,500 and Lean $46,600.

Over time, that extra annual 3% in Fatcat expenses will have a significant impact on your compound returns.

Management Expense Ratio

The Management Expense Ratio (MER) reflects the annual cost of operating a mutual fund. Note that some areas of the world call this the Total Expense Ratio to reflect the inclusion of all costs. Then they consider the management fees separately. Just ensure you understand what is included in any fund ratio calculation.

The MER is made up of three fee or expense categories: management; administrative; marketing.

It does not include costs associated with buying and selling fund investments (e.g., commissions, loads, brokers’ fees).

Management Fees

A large portion of the MER is the fees paid to the fund managers or investment advisors.

These are the people that research possible fund investments, determine assets to include in the portfolio, monitor the ongoing performance, and make decisions to sell any assets.

This fee may also include investor relations and fund administration costs, although normally these latter expenses are include in the administrative cost category.

Management fees can be structured in a variety of ways. In the majority of funds though, management fees are based on a percentage of AUM. For example, a fund may have a stated management fee of 0.60% AUM.

In general, the greater the amount of work required from the managers, the larger the fee. So there can be a wide disparity in management fees between funds.

Actively managed funds require more work than passive funds.

Funds that focus on niche markets or areas with relatively poor public information on companies also require greater effort in analyzing and selecting investments.

Funds requiring complex trading strategies tend to need more work than simpler strategies.

When comparing MERs or the management fee itself, always make sure you compare apples to apples.

For example, it might make sense that a management fee between two Africa international equity funds is 2.10% AUM versus 2.00% AUM. One would expect that funds of similar size, investing in the same asset class and region, to have relatively equal MERs (if not, you need to find out why before investing).

But it may make less sense to compare these funds against a U.S. large cap equity fund. The U.S. fund likely has better available research and corporate information on possible investments than do the companies based in Africa. It is reasonable to expect greater work being required to assess African companies. Greater work equates to higher fees.

Or perhaps the U.S. large cap fund has AUM of $10 billion. In comparing that with another fund holding only $100 million in assets, you may expect the larger fund to have a lower MER. For the simple reason that the bigger fund has more assets against which to spread its costs. Would you expect a fund with $10 billion in assets to require 100 times the management costs versus a $100 million fund?

Popular in hedge funds, you may also see performance based management fees on top of the standard charge. The performance fee may be based on on profits earned (e.g., 20% of all positive returns), on profits above a designated “hurdle rate” (a benchmark return such as the U.S. Treasury Bill rate, the S&P 500, etc.), or on profits above the “high water mark” (the highest previous return for the fund).

Administrative Costs

Administrative costs cover the back-office costs of operating a fund.

These may include: legal fees; accounting and auditing expenses; record-keeping and regulatory filings; shareholder and other statement preparation and distribution; custody services; staff salaries; rent and utilities on office space.

One would expect that greater administrative costs would be attached to larger funds. And that is probably a fair assumption in hard dollar terms.

However, as administrative costs are also reported as a percentage of AUM, larger funds may appear to have lower costs. This is an advantage of aggregating one’s capital in a mutual fund. You can spread out the administrative costs amongst many investors, creating an economy of scale that benefits you. Same as with fund management fees.

Perhaps ABC fund has annual administrative costs of $2 million. DEF fund has administrative costs of $3 million; 50% greater than ABC. But DEF has assets of $3 billion, whereas ABC only has assets of $1 billion. This equates to 0.2% of AUM for ABC, but only 0.1% for DEF. While ABC has lower administrative costs in absolute dollars, DEF has a better ratio.

Note that while this ratio might be interesting, it really tells us nothing as to whether either ABC or DEF is well-managed.

The best one can do is to compare the costs to funds of similar size and in the same investment categories.

Marketing Costs

Often mutual funds break out their marketing and distribution expenses.

In the U.S., these fees are known as 12b-1 fees. The designation refers to a relevant section of the Investment Company Act of 1940.

In the U.S., a maximum of 1.0% of the fund’s net assets may be used for marketing the fund.

It may seem strange to pay an annual fee to market a product that you already own. The belief is that by marketing a fund, it will attract new investors. New investors will add to the asset base, creating an economy of scale for the administrative costs. This will result in net savings for shareholders.

I have not seen any evidence to support this contention. And in this age of mutual fund investing, investors look primarily at performance and costs when screening funds. What they may see on a television advertisement or hear about from a sales representative is way down the list of review points. Or it should be.

I consider these costs a waste of money for investors and suggest you do the same.

Total Expense Ratio

Neither the sales charges nor fund transactional costs are included in the MER.

The sales charge (i.e., commission or load) is not a fund expense. Rather it is a direct cost to the investor. It makes sense that it is not included in the fund’s cost structure. Same if you have to pay a brokerage fee to buy or sell the fund.

Transaction costs incurred by the fund when buying or selling fund portfolio investments (e.g. brokers’ commissions, spread differences, etc.) are expenses of the fund.

Total expenses are calculated by taking the management expenses (management fee, administrative, marketing) and adding in the transaction costs.

To obtain the total expense ratio (TER), simply divide the fund’s total expenses by the fund’s total assets (AUM). As stated above, many jurisdictions now blend MER and TER, so you may only see the MER stated. If so, it should also include these internal trading costs.

To further complicate matters, sometimes TER relates only to Trading Expense Ratio. So it is separate from, rather than cumulative with the MER. Anything to confuse investors. And yes, that is a goal of fund companies.

Internal Transaction Costs

In assessing funds, perhaps one fund has a relatively high TER versus its MER. That means the transaction costs are high. This can be due to poor order executions, high spreads between bid and ask prices, or high portfolio turnover.

High transaction costs may be a red flag when deciding to invest. Unless high frequency trading is the strategy.

If the fund is not doing a good job of executing trades, it may not be getting the best prices on its investments. It may also be paying too much in commissions. Both of these negatively impact returns.

High turnover means more frequent trades (and costs), which impairs profitability (unless that is the strategy).

High turnover may indicate that fund management lacks confidence or patience in their investment selections with all the selling of current holdings and replacement with new assets. This could be a warning about their future performance.

In some instances, it may indicate churning. That is, excessive trading within an account to drive up brokers’ commissions. Less a problem with mutual funds than in other circumstances (e.g., managed accounts), but it can still occur.

Finally, every time an investment is sold, there may be a tax implication for fund shareholders. Generating capital gains too early can accelerate the shareholder’s personal tax obligations and hurt compound returns.

Conclusion

First, when assessing fund costs, always compare like funds. Size, style, geographic region, asset classes, etc., they all impact the cost structure. Compare within the category in which you wish to invest if you want meaningful analysis.

Second, all else equal, choose funds with the lowest expenses. Unless you truly believe that a higher cost fund will generate superior net returns than a lower cost option, stick with the lowest cost possible.

Of course, that is not to say that you should invest in under-performing funds simply because they are cheap. But do place a heavy emphasis on costs when you do your total analysis.

Remember, future returns may or may not be the same as past performance. But there is a high probability that the cost structure of a fund will be consistent in years to come.

As we saw above, what may seem like small differences in costs will create substantial variances in investor wealth over time due to compound returns.

Make your money work for you.

Maximize the amount invested and earning actual returns.

Minimize the money you pay to others and receive no return on.

Mutual Funds: Transaction Costs

We previously reviewed the perceived advantages of investing via mutual funds. Funds are a great way for investors to build well-diversified portfolios and meet long-term investment objectives.

However, there are potential downsides. Not necessarily negatives, but areas investors need to be aware of and take measures to protect themselves against.

This is why we diverted to the concept of compound returns over the last few posts. How time horizon, cost structure, and rate of return can greatly impact long term wealth accumulation. Even 1% here or there can alter asset growth.

We will consider how mutual funds (or any investment) may negatively impact your annual net returns and thereby significantly impair wealth accumulation. Today, transaction costs incurred when buying and selling open-end mutual funds.

The Importance of Transaction Costs

As we saw in compound returns, every dollar you pay to someone else is a dollar of extra returns that must be earned just to break-even. And every dollar lost, is a dollar that cannot compound over time. A significant problem for investors attempting to achieve long-term portfolio growth.

Transaction costs can be a major expense when investing. Less so now that most investors use online brokerage accounts. $10 per trade is easier to handle than in the days of full service brokers.

As well, the introduction and proliferation of exchange traded funds has worked to reduce loads (and, as we will review later, expense ratios) in mutual funds.

Mutual Fund Transaction Costs

Funds may be subject to a sales charge when investors buy or sell shares or units of the fund. This transaction fee compensates brokers or internal fund salesmen for selling investors the fund.

The fee is known as the load or sales commission.

You may encounter front-end, back-end, or declining loads. Some funds may offer more than one option.

Note that different load options may result in other different terms or conditions. For example, a no-load fund may charge higher annual fees than the exact same fund with an upfront sales commission. Clearly understand the total fee structure, including ongoing costs, before choosing a load option.

Although similar to the broker’s commission when you trade a marketable security, be aware that a load is not a commission in that sense. If investing directly via the mutual fund company, there should be no broker’s transaction cost. Two different concepts.

Front-end Load Funds

A front-end load is paid to the mutual fund company when you purchase units or shares of the fund. In future, when you sell the investment, there is no load paid.

For example, on January 1, 2018 you invest $1000 in an global equity fund that has a a 5% front-end load and a closing net asset value (NAV) of $50 per share. You will pay $50 as a sales fee (5% of the $1000) and receive 19 shares of the fund with your remaining $950.

And yes, your fund has a lot of work just to recover the compound returns you will lose over time on that initial 5% load.

Back-end Load Funds

A back-end load is the opposite of a front-end load. Instead of paying a sales fee when you purchase shares of the fund, you pay a fee when you sell.

As you pay the transaction fee only at the end, back-end loads are also known as deferred loads or deferred sales charges.

Using our previous example, let us say that the 5% load is a back-end instead of front-end.

Had you invested $1000 in the global equity fund at $50 per share, you would receive 20 shares as the entire amount would be available for purchase.

Perhaps in 6 months the fund rises to a $60 per share NAV. You decide to sell your 20 shares and will have gross proceeds of $1200. As you now have a deferred load, you must pay the 5% sales fee. But not on the initial capital invested as in the front-end. Rather, you will pay on your gross proceeds. In this case, you will be charged $60.

The trade-off between the front and back-end loads is two-fold.

As you hope to experience appreciation in the value of the fund, you should expect to pay more for a back-end load with the same percentage fee than with a front-end load.

Because of the time value of money, the longer you hold the shares, the better the back-end load will look. If you intend to keep the investment for a long time and have a choice between equal fees, back-end funds should be the better option.

Declining Load Funds

Many back-end loads offer declining sales charges over time.

This is an incentive for investors to stay in the fund for longer time frames.

For example, perhaps the back-end load is structured as follows: 5% sales charge if sold within 3 years; 3% sales charge if sold after 3 years but before 7 years; 0% if sold after 7 years.

If you do not sell for at least 7 years, you will not be charged any fees.

In our example above, you consider selling your fund shares on December 31 in the years 2018, 2022, and 2027. The per share NAV on those three dates is respectively $60, $80, $100.

With a declining back-end load, you would pay a sales charge of $60 (2018), $48 (2022), and $0 (2027). The longer you hold, the better the deal. In this example, the dollar value sales charge decreased even though the total assets grew over time.

Often, declining loads appear very reasonable as many investors plan to hold onto funds for extended periods. However, be aware that the best of intentions often go awry. Personal circumstances may change and you may need to divest before the back-end load falls to nil.

As mentioned above, check to see how a back or deferred load may result in other charges or expenses. If you save money on the commission, you may just be paying for it under another guise.

No-load Funds

No-load funds do not charge a sales fee.

All else equal, no-load funds are more desirable to investors than any type of load fund.

Every dollar of investor capital goes to acquire shares of the fund. And every dollar of gross proceeds upon sale is due to the investor. None of the investor’s funds go to pay the salesman.

Of course, load fund salesmen will make compelling arguments as to why paying a sales charge to acquire a particular load fund is worth the fee.

While their load funds may be excellent, always keep in mind that the salesman is paid for selling the fund. I would add that “excellent” is a relative term. You need to assess whether the expected performance of the fund over time justifies paying someone for the privilege of owning it.

Many salesmen may be principled and want to find the you best fund for your needs. But some salesmen may push customers towards funds that provide them with the best sales charge. When dealing with people selling load funds, always be cautious as to their intentions.

Of course, the same caveat as with deferred loads is true for no-loads. You need to examine the other fund costs to see if you are paying a hidden commission.

Commissions on Mutual Funds

As I wrote above, a sales charge is not a broker’s commission. It is compensation from the mutual fund to the salesperson.

Open-end mutual funds are bought and sold directly from the mutual fund company. They do not trade on exchanges and you do not require a broker to transact trades on your behalf.

That said, to improve investor accessibility to mutual funds, many fund families allow investors to buy and sell funds through the investor’s brokerage account.

So if you purchase open-end funds (load or no-load) through your broker, you may be required to also pay a commission to the broker.

Not all funds are available through all brokerage firms. Some can only be purchased or sold directly through the fund company. Other funds may only be bought or sold through specific brokerage houses.

The number of funds sold can vary substantially between brokers. If you plan to invest in mutual funds, select a broker that offers access to a wide variety of funds.

As an aside, remember that we are discussing open-end mutual funds here. There are also closed-end funds. Closed-end funds do trade on exchanges and you do need to trade them through a broker. You do not buy or sell closed-end funds via the fund itself.

Closed-end funds do not charge any load. But they will always have a broker’s commission. And, as we shall see later, the same is true for exchange-traded funds.

No-Transaction Fee Funds

If you can buy a no-load mutual fund directly from the mutual fund company and not have to pay any broker’s commission, why would you ever buy a no-load fund through your broker?

Good question.

Outside of wanting to keep your investment portfolio all in one place (without having to set up accounts for your stocks and bonds at TD and your mutual funds in additional accounts at Fidelity and Vanguard), I do not have an answer for you.

I guess many other investors could not come up with reasons either.

Which leads to no-transaction fee funds.

Most brokers have arrangements with certain mutual fund companies to sell funds without charging a brokerage commission. This levels the playing field between fund companies and brokers and allows investors to access a variety of funds without incurring brokers’ fees.

There may be differences between brokers as to which fund families they will waive their commissions on. So check ahead before making investment decisions (or even choosing a broker to deal with).

The brokers give up their commissions to incent customers to buy funds through them. However, no-transaction fee program fund participants typically pay a fee to the broker each time a no-transaction fund is traded. This remuneration from the mutual fund company to the broker is a cost to the fund. And that cost is passed on to fund shareholders, thereby negatively impacting fund performance.

So even though you are not paying commission on the transaction, you will pay indirectly.

Load, No-Load or No-Transaction Fee?

I take a “best of breed” approach to investment recommendations. That is, I try to find the fund that best meets the needs and objectives of a client. My business model excludes my receiving commissions, etc. I have no vested interest in any funds. You pay my fee, you get what is best for you.

That said, with a few exceptions, I do not generally recommend load funds to investors. There are so many no-load options available that you have ample selection for all your portfolio needs.

Exceptions might relate to niche funds that specialize in small market segments where there are no suitable no-load alternatives. For investors starting out or simply wanting to create a well-rounded investment portfolio, I likely would not recommend niche funds anyway.

Exceptions might also relate to load funds with superior net long-term performance. Though this tends not to be the case. Research indicates there is no correlation between loads and fund performance. However, in assessing individual funds, a specific load fund might have superior returns over a similar no-load fund.

You will pay for a fund’s costs in one form or another. Just because you are not paying a sales charge does not mean you are not paying any fees. They may just be buried amongst other expenses. Always focus on a fund’s overall costs and its management expense ratio when deciding on the right fund.

One final comment. Sales commissions may be negotiable. It often depends on the fund company and the level of assets you intend to purchase or bring in. But if you do not ask, you will never get. And every dollar saved, is worth a lot more over time in your portfolio.

Okay, enough on mutual fund transaction costs.

We will take a further look at fund costs later.

Specifically, annual fund operating costs and the management expense ratio.

Advantages of Mutual Funds

Today we will explore the advantages of mutual funds as investments.

I believe mutual and exchange traded funds (ETFs) should be the cornerstone of most investors’ portfolios. This is especially true for investors who have have yet to accumulate significant wealth. However, even for those with substantial portfolios, funds are often the wisest investment path.

Why do I think this? What are the advantages of investing in mutual funds?

Investment Options

As we saw in our Mutual Fund Introduction, there are a vast number of funds available for purchase in a multitude of investment styles and asset classes.

Previously, we reviewed various Mutual Fund Categories. You can invest in specific asset classes, such as fixed income or equities. You can also invest in funds that follow specific investment strategies or analytics. If you want funds following value or growth strategies, no problem. You want dividend yield, there are many funds to invest in. Small-cap, biotech funds from Israel? You can find those too. Pretty much everything can be found in a specific fund.

This allows you to easily create any combination of assets within your portfolio. Also, to quickly adjust these combinations as your personal circumstances change.

You may even find funds that allow access to investments that you could not feasibly acquire on your own. Real estate, venture capital, and fine art are examples.

When we discuss asset allocations and portfolio returns, you will see that having ready access to a wide variety of assets is vital to investment success.

Diversification

Diversification is an extremely important feature of funds, especially for smaller investors.

Diversification allows one to reduce overall portfolio risk while maintaining the same level of expected returns. It also allows one to invest in riskier assets that have higher expected returns without increasing the overall portfolio risk.

A very useful tool to incorporate in one’s investment strategy. Probably the most important aspect of successful investing.

For more information on diversification, please refer to three earlier posts: An Introduction to Diversification; Diversification and Asset Correlations; Asset Correlations in Action; A Little More on Diversification.

Due to the number of investments held within a typical mutual fund, there is normally strong diversification already built in. Not always, as we shall discuss later, but usually.

Diversification within a fund will relate to the category of the fund. The diversification may be between: companies in specific sectors (e.g., oil and gas exploration equity funds); entire sectors and industries (e.g., consumer product equity funds); geographical regions (e.g., country specific, international, or global funds); maturity dates (e.g., long term bond funds); asset classes (e.g., balanced or asset allocation funds).

Smaller investors may not be able to diversify on their own through individual assets. This may be due to the lack of overall wealth, an inability to access investments across all asset classes, or the prohibitive cost in trying to diversify with limited funds.

As one’s wealth grows over time, an individual may be able to achieve adequate portfolio diversification on his own. But for any investor, even larger ones, mutual funds can provide excellent diversification on a cost-effective basis.

For example, the RBC O’Shaughnessy All-Canadian Equity Fund provides exposure to a variety of Canadian public companies. As at February 20, 2018, it holds 104 companies in its portfolio. How many investors have the wealth to invest in 104 different companies? Not to mention the time to analyze and track a portfolio of that size.

Cost Effectiveness

Diversification is crucial in investing. But it can be a costly endeavour.

To create a well diversified portfolio requires a significant number of different investments. In diversifying away the nonsystematic risk in equities alone may necessitate holding at least 30 to 40 different stocks. Then factor in fixed income, money market, and other asset classes (e.g., real estate, commodities) and one’s portfolio can become quite large.

This is especially problematic for investors in two cost-related ways.

First, when trying to diversify within and between asset classes, the average small investor tends to spread themselves thin when acquiring investments.

Second, buying marketable securities (stocks, bonds, etc.) involves paying commissions on each trade. The less securities purchased, or the greater the number of trades made, the higher the relative cost of the acquisition.

For example, to invest $6,000 in 30 different stocks, you are only able to invest $200 in each company. That may not allow you to purchase very many shares of any company. In some cases, $200 might not even allow you to acquire one share in some popular companies. Amazon, Google, Tesla (and many others) would be excluded from your investment options as all currently trade above $200 per share.

And even with low online brokerage rates of $10 per trade, you will spend $300 on commissions to buy 30 different companies (as opposed to only $10 had you bought just one stock). You will need to generate a portfolio return of 5% simply to recover the commissions paid. Not an easy endeavour.

By investing through mutual funds, you pool your money with many other investors. This provides an economy of scale to reduce the individual impact of commissions and allows for the purchase of assets of any value. Even Berkshire Hathaway A shares at a February 20, 2018 price of $306,000 per share.

Economies of scale also allow for better pricing on fixed income instruments. As greater amounts of money market instruments are purchased, the offered interest rate is typically higher than for smaller investments.

A third “cost” is the value of your time. Unless you love to spend your spare time analyzing investments (granted, who does not love that), then there is the cost of your time. Even investing in 30 stocks requires a lot of effort to identify potential investments and monitor your holdings. Funds simplify the process and time required.

Ease of Investing

One thing that brokers and mutual funds are great at is making it very easy to invest.

You can invest in funds either through the specific fund itself or via your brokerage account.

Note that some funds may not be available through your broker. Different brokers may offer different funds. Some offer a better selection than others. When choosing a broker, find one that offers a wide selection of funds for purchase.

There are many funds that do not have sales fees (front or back loads) which saves money. Often, brokers waive commissions for the purchase of certain funds that they sell. Or there may be no commissions when shifting money from one fund to another in the same fund family.

Again, when choosing funds or an online broker, consider the transaction costs associated with the fund purchase. Given the number of funds available, you should be able to fulfill your investment objectives entirely with no-load funds.

There are very few reasons why you should pay a sales fee or commission on a mutual fund. Avoid.

Many funds allow relatively small initial investments and even smaller subsequent purchases.

Some funds allow for automatic investments via monthly/quarterly/etc. direct debits from your bank account. These Direct Purchase Plans (DPPs) allow investors to invest without making an effort. It is also a superb way to engage in dollar cost averaging. A concept you should utilize and one we will cover later on.

Some funds offer Dividend Reinvestment Plans (DRIPs). Any distributions made from the fund are automatically reinvested into additional shares of the fund. Except for having to pay tax on distributions you do not physically receive, this is an excellent way to invest and accumulate wealth over time.

Liquidity

Liquidity, or ease of divesting, is another advantage of mutual funds.

Asset liquidity is important when assessing investments. To refresh, please review Liquidity Risk for Investors.

With some exceptions, most open-ended mutual funds are valued daily. These funds normally redeem (i.e., buyback) your shares (or units) each day based on the fund’s closing net asset value. Because the fund itself redeems the shares, open-ended funds are usually extremely liquid.

And by posting net asset values daily, investors have high certainty as to the proceeds they will receive on disposition.

Professional Management

Some believe this to be an advantage. Others actually believe it a negative.

In theory, having a mutual fund professionally managed should be a positive. The investments made are well researched. The portfolio is monitored to ensure proper construction for the style (e.g., a value equity fund has the best possible value stocks). And when it is appropriate to sell securities, they are sold in a timely manner.

In short, you are letting an investment professional make the investing decisions for you.

Assuming you are not a professional yourself, that should mean better investment decisions will be made than if you were left to your own devices. Also, by delegating asset management to a professional, you do not need to spend your precious time, researching and monitoring multiple investments.

In practice, this advantage does not always arise. In delegating the investment decisions to others, you must pay for that privilege in higher management fees. That might be okay if the annual performance of actively managed funds exceeded passive (no professional decision making) funds. But that is not always the case. Nor even usually.

We will look at the active versus passive debate in an upcoming post as it is an important issue.

While these advantages make mutual funds appear the ideal investment, there are some potential drawbacks or issues that must be considered when investing in mutual funds.

We will look at these next time.