A potential disadvantage of mutual funds for investors may be the fund costs. A possible sales commission, or load, when buying or selling. Plus the ongoing management expense ratio charged to the mutual fund. These costs can significantly impact mutual fund performance. And investor wealth accumulation over time.
The “load” is the sales commission that may be charged when buying and/or selling a mutual fund (or other investment product).
Loads, or commissions, may come in a variety of forms. Front, back, or declining, are three common examples. We review the similarities and differences between these different types. And when one may make better sense for your own requirements.
“Are there any no-load funds?”
Not paying a sales commission to buy (or sell) a mutual fund seems like the smart move. There are many funds that do not charge loads when buying or selling the investment.
However, there are issues to watch out for when investing in no-load funds. The key one tends to be that the ongoing annual expense charges in the fund may differ between load and no-load offerings.
“How does ‘no-load’ differ from ‘no-transaction fee’ costs?”
No-load means you do not pay a sales commission when buying or selling. That commission would have been paid to the fund company.
No-transaction fee refers to the trading cost charged by the broker you use to buy or sell. Normally, investors trade directly through the fund company. With no transaction fees charged, only commissions.
Increasingly, banks and online brokers have developed relationships with certain fund companies. Allowing their clients to access mutual funds via the brokerage, rather than having to set up a new relationship with the fund company.
“What is a mutual fund’s ‘Management Expense Ratio’?”
The Management Expense Ratio (MER) is a separate cost from a sales commission.
The MER covers the ongoing costs of operating a mutual fund. Administration, marketing, trading.
The largest cost tends to be the fund management fees. For actively managed mutual funds, this will be the main component of the MER. For index funds, this should be zero.
There may also be continuous retrocessions, or “trailer-fees”, embedded in the MER. These are often paid to the fund salesperson who sold you the investment product.
What, you thought that “free” financial advice was free?
“How does this all work in the real world?”
We take a look at one the larger Canadian equity mutual funds.
How loads work. How they differ. How MER can vary between fund’s different share classes.
“What do most investors buy? Front, back, declining, or no-load funds?”
Over time, there has been clear trends in mutual fund investor buying patterns. In many areas.
As far as loads, the shift over time has been to no-load products from load products.
“Can you explain more on MERs? What does the data tell us on costs and investor trends?”
We review actual data on typical mutual fund costs.
Particularly, how MERs tend to correlate to the specific type of investment. In general, the more complex the fund, the higher the MER.
We also look at investor trends in seeking out lower cost mutual funds. Why this is the case.
“What lessons can I learn from mutual fund costs and investor behavior?”
There are many great lessons to learn from what is happening in the real world.
I think this point is important. Theory is great. But the key is seeing the empirical evidence.
I may tell you that investment costs are a key predictor of future fund success. That active asset managers do not beat their benchmarks on a consistent basis over time. Therefore, cost minimization is crucial to investing success. It sounds good. Makes sense to me.
But what about the real world, not the land of theory? Here, we can see that investors are making that shift based on the actual data. Not in a lemming or investment bubble crazed manner. In a consistent change over time as the lessons of low cost investing sink in.
This will be a focus moving forward. Why you should consider low-cost investments for your portfolio?
What are the perceived advantages in using mutual funds to create a well-diversified investment portfolio? Fund companies usually claim: easy diversification; painless investing; high liquidity; low-cost; professional asset management. A look at these potential advantages of investing in mutual funds.
“How can mutual funds provide my portfolio with ‘easy’ diversification?”
There are a vast number of mutual funds, covering almost every asset class and subclass. And every style or type of investing you desire.
Many mutual funds are well-diversified within their asset class or subclass.
If you want total ease, there are balanced or target date mutual funds that may allow you to invest all your capital in one, single investment. Investing cannot be more simple than that.
Mutual funds may provide access to investments that smaller investors cannot access on their own.
Perhaps you want venture capital in your portfolio. You may require a significant cash investment to access some venture capital investments. Many of which may have relatively poor liquidity and necessitate a 12-14 year investment period. Factors that may exclude a venture capital investment for many smaller investors. However, a venture capital fund may allow for smaller capital contributions and more consistent cash flows. Making this more attractive for smaller contributors.
“Why is investing in mutual funds considered ‘painless’?”
Mutual funds can be very cost-effective and efficient to buy and sell.
Initial purchases tend to have reasonable minimums. Subsequent investments are often at even lower dollar amounts. As well, there are normally direct deposit systems and dividend reinvestment plans. Both of which facilitate future purchase patterns.
Fund companies track and disclose fund holdings and performance on a continuous basis. Allowing for investors to easily monitor their investments. Fund companies also produce tax data which simplifies the investor’s personal tax preparation at year end.
Painless investing is indeed a big selling point for mutual funds. And a large differentiating factor between fund companies in trying to attract new investors. So, yes, mutual fund investing tends to be simple and straightforward.
“How can mutual funds help improve investor ‘liquidity’?”
Common mutual funds can normally be bought and sold on a daily basis. Based on the fund portfolio’s closing net-asset-value. This results in decent liquidity within larger, more established mutual funds. And for investors with relatively low amounts of money in a specific fund.
Note that some mutual funds may allow for purchases and redemptions on a lesser basis. The less frequent the ability to trade, the more likely you will face liquidity concerns.
“Why are mutual funds considered ‘low-cost’ investments?”
Attempting proper diversification via individual, non-diversified assets is typically neither “easy” nor “painless”. It also tends to be relatively expensive.
In transaction costs, to buy or sell multiple investments. In paperwork cost, to monitor the portfolio and deal with tax details. Or, in fees to delegate your portfolio management and accounting to a professional.
Also, in opportunity cost. The commitment required to monitor and maintain the investment portfolio if you do it all yourself. When there may be better uses of your valuable time. That, too, is a cost.
Mutual funds can provide cost-effective diversification. Especially for those with less capital.
Fund companies pool many investors’ funds to spread out investments and risk. Large funds enjoy economies of scale to widely disperse ongoing expenses. Both of these benefit the individual investor.
“Having my money managed by professionals is obviously an advantage, right?”
The same concept holds true for professional asset management within a fund.
By spreading out the portfolio management fees over a wide number of investors, the fund can hire competent asset managers to improve fund performance.
Or so it goes in theory. Having an investment expert make portfolio decisions should be better than non-professionals, such as most people reading this or watching the video.
However, when we drill deeper into mutual funds, professional asset management may not always be the advantage that it seems to be. Yes, a bit of foreshadowing there.
Investors often use mutual funds to fill out target asset allocations and create well-diversified investment portfolios. In this introduction to mutual funds, we cover the quantity and asset size of available funds. Also, the variety of asset classes, subclasses, and specialty areas you can invest in using mutual funds.
It is extremely large, both in number of funds and assets.
We look at the number of mutual fund and assets under management. In Canada, the US, and the world.
How the mutual fund industry has grown over the years. As investors shift from investing in individual, non-diversified investments into better diversified investment products. As increased competition has continued to reduce product costs. And as investor knowledge has improved over time, resulting in the demand for more customized offerings.
“What are some of the asset classes that I can access with mutual funds?”
Investors can invest in every possible asset class and subclass. Based on your overall investment strategy, shorter term tactics, and to enhance diversification in your base portfolio.
We discuss some of the subclasses and ideas on how to assess them for your portfolio.
“How can I find the better funds when there are so many available to buy?
We discuss fund ratings and rankings as one tool to compare performance between mutual funds in an investment category.
There are a variety of analyst rating systems. We use Morningstar as an example in this video.
“What other considerations may arise with mutual funds?”
We discuss hedging versus foreign currency exposure. Or investing internationally, at all. Most Canadian investors have a substantial home country bias in their equity portfolios.
Perhaps you prefer a balanced mutual fund, which may match your target asset allocation. Or a target date fund that takes a balanced approach, but rebalances over time until its (and presumably your own) retirement date. So you get everything all in one investment product. Which improves simplicity in your investment management.
Maybe you want alternative asset classes or niche sectors. Private equity, commodities, collectibles, real estate. Or specialty areas such as Environment, Social, Governance (ESG) investments. A hot investment sector currently.
You have defined a target asset allocation. How should you now build your investment portfolio? By investing in non-diversified, individual assets? Such as common shares of Apple or Tesla. Or is it wiser to invest via well-diversified investment products? Such as mutual or exchange traded funds.
This is a “build your own” portfolio approach. You analyze potential investments across various asset classes and subclasses. Then invest in securities deemed “best in class” to fill out your target asset allocation.
In theory, as you only own the “best” investments in each class, maybe shares of Apple, Google, or Netflix for equities, you should create a strong portfolio. One that outperforms your benchmarks.
Whereas if you bought a S&P 500 index fund, you purchased 500 different companies, whether you want them or not. Great to hold Facebook, Apple, Netflix, and Google in the fund. But you also “own” Norwegian Cruise Lines, Carnival, and United Airlines. Companies whose shares plummeted in 2020 due to COVID.
By owning the “FANG” stocks and avoiding the cruise lines, you would have beat the index return.
Makes a lot of intuitive sense. And the main marketing tool from active asset managers.
This is a doable approach if you have the critical mass of capital to diversify across your target asset allocation. If you are a High Net-Worth Investor, a “build your own” portfolio can make sense.
It may also be a good approach for active traders. Who create non-diversified portfolios and like to jump in and out of specific positions. Or for those who like to tactically invest or engage in market timing. Utilizing a portfolio of individual securities may be a positive for these investors.
Okay, that sounds quite easy. Investing in individual securities is definitely the way to invest.
But it is not that easy in practice.
“What are the potential problems with investing in individual securities?”
While doable, it may not be practical for many investors.
Retail investors may lack the critical mass of capital to manage this approach effectively and efficiently. Though, often smaller investors can find cost effective ways to help acquire common shares. Dividend Reinvestment Plans tend to be very useful.
Can you manage investment fees? If you need a minimum of (say) 30 equities, 15 bonds, and some cash, transaction costs can add up over time as you build or adjust positions. It is much more cost effective to invest $100,000 at a time in an investment, as opposed to $300.
You may also trigger taxable events in buying and selling individual securities.
Can you consistently pick the winners? There are a lot of asset classes and subclasses. With a myriad of individual investments in each. How do you find the “best”? An issue we will cover in future episodes.
Can you manage the opportunity cost? The time required to monitor and amend the portfolio. You cannot simply buy a stock and forget about it. Quality changes over time. Better investments may emerge. If you have a portfolio of 50 assets spread globally, that may require significant time. Do you have the spare time to deal with the portfolio? Or hire someone who does?
Can your properly diversify your portfolio with 50 assets? Investment theory says yes, but you need to do a good job combining asset correlations to create an optimal portfolio. The less securities, the more challenging it will be.
All of these are potential disadvantages in individual securities. But the difficulty in optimally diversifying may be the biggest negative. The greater the number of investments required to diversify is what causes problems in the other areas. With investment expenses, having to consistently find winning investments, and the ongoing time required to manage the portfolio.
What are open-end and closed-end mutual funds? How are they similar? How do they differ?
What about exchange traded funds (ETFs)? How do they compare to open and closed-end mutual funds?
And hedge funds? Is that something retail investors typically use?
If you want additional detail on these different investments, please read “Investment Funds”.
“What are some of the pros and cons of investing via funds?”
Unsurprisingly, many of the potential disadvantages associated with individual securities are positives in investment funds. Investors do not need much money to invest. Well-diversified products. Many are low-cost for investors. Actively managed funds are run by investment professionals. Investor portfolios will have very few investments versus an individual approach. Much less time commitment to monitor.
And the advantages of associated with individual assets tend to be potential concerns with funds. You may not own exactly the securities you want. If you passively invest, you will own the entire index. If you invest in actively managed funds, there may be some fund holdings you do not like.
This episode provides more of a high level comparison with the funds available for investors. We will dig much deeper into investment funds in upcoming episodes. Especially, the potential advantages and disadvantages of open-end mutual funds and ETFs versus individual securities. And in comparing mutual funds against ETFs as investment vehicles.
What is the Equity asset class? Why invest in common shares? How does your life cycle phase, personal circumstances, and risk tolerance impact your target asset allocation to equity investments?
Then we drill down into the diversification and risk-return characteristics of various equity subclasses.
For example, investing by style. Value versus growth investing. Maybe your focus is on generating dividend income rather than capital gains. Perhaps you want to invest based on market capitalization. Mega companies like Apple, Nestle, and Toyota. Or down to small, micro, or nano capitalized companies.
I discuss differences between domestic and international equities. How the risk-return profile and asset correlations differ between developed, emerging, and frontier capital markets. There may also be differences between developed markets, such as EAFE (Europe, Australasia, Far-East) and the US. As well as between individual emerging markets. India and China are much different than Colombia or Qatar.
Not all equities are equal. Two investors may have the same percent allocated to equities. But the characteristics of that allocation may be vastly different.
Note the difference between “global” and “international”. Domestic equities are from your home market. International equities are from around the world, excluding your domestic market. Global include both domestic and international securities. Useful to remember when assessing investment products.
Next we move back into how your life cycle phase affects your equity asset allocation.
“How should Accumulators utilize equities in portfolios?”
Because Accumulators tend to be young, they have a very long time horizon for investing. At least, for the major goal of retirement. The time horizon means Accumulators can handle enhanced portfolio volatility and expect higher returns over time. This suggests heavy exposure to equities.
For many Accumulators, “heavy exposure” means a 100% equity allocation in their early years. However, as discussed with cash and fixed income, there are other factors that recommend some allocation to the other classes. Diversification benefits and short term objectives are two good reasons.
“What about those in the Consolidation phase?”
Consolidators still have a relatively long time frame until retirement. That suggests equities.
However, Consolidators may have more near term objectives and may now decide to focus on diversification as they have more wealth accumulated.
Because Consolidators do have some capital built up, they have the critical mass to better diversify into niche equities than do Accumulators. An Accumulator be may smart to invest in a cost-effective global equity fund as they build an investment foundation. A Consolidator may look for specific investments to improve diversification or try and take advantage of current trends.
Consolidators may have similar equity allocations as Accumulators, but the breakdown within the equities may differ.
“And for those in their Spending phase?”
As you might guess, being at, or near, retirement age means some shift to safer, more liquid assets. Such as fixed income. So the equity allocation is usually lowered when people become Spenders.
But there can still be a long time period to live. With people often living into their 90s, investors might have 30 years to live off their wealth. With inflation and low returns on fixed income, that means Spenders may still need a decent equity allocation.
But the allocation with equities may change. Instead of higher risk frontier markets or micro-cap investments, there may be a shift into more Blue-Chip investments. Or value stocks that generate dividend income, but still have upside capital gain potential.
“How does an investor’s risk tolerance factor in to the target allocation?”
In two key ways, as we saw above in the examples.
One is in the overall equity target allocation. A person’s circumstances or risk tolerance will drive the overall equity allocation.
If you are young, with a long time horizon, accepted investment theory might suggest 80-90% in equities. Whereas, for retirees, maybe a general level should be 50-60%, then adjusted down as years pass.
Also, what is the overall level of wealth. If you have $10 million in assets and only need $50,000 a year to live on, then you can take a low risk allocation with little allocated in equities. If you have $500,000 saved and require $50,000 annually, then you will need to take on more risk.
That is more the unemotional, rational approach to risk and an equity allocation.
However, your emotional view of risk may adjust the equity allocation further.
For some retirees, 50% in common shares may be too high for their comfort. And ability to sleep at night. They may prefer the safety and stability of cash or fixed income over the higher volatility of shares. Likely, these same investors had relatively low equity allocations even in their younger years. Some people are simply more risk averse than others.
Two is the equity investments within the equity allocation itself.
Do you prefer relatively lower risk equities? Blue-Chip companies. Value stocks. Dividend producers.
Do you gravitate towards higher risk investments? Micro-cap stocks. Growth. Frontier markets.
What about the investment itself? A well-diversified global equity fund. Versus individual companies. Maybe with a focus on small-cap mining companies operating in Africa.
The risk-return profile can vary wildly within an asset class. Your personal risk tolerance will dictate the way you invest within that class. And that can create much different risk levels for the overall portfolio.
A relatively short, but good overview of equity considerations in your target asset allocation. Very useful to compare the life cycle phases between cash, fixed income, and equities. Also, how both your personal financial situation and risk appetite will impact your equity allocation. As a percentage of the entire asset allocation. As well as the riskiness inherent in the equities themselves.