The Smart Canadian Wealth-Builder: Chapter 19, MUTUAL FUNDS -- An Investment Vehicle
Click HERE to buy the book!
"Our sixth Saturday -- we're moving along nicely, Kevin and Jenny. I'm impressed! If you stick with me for a few more Saturdays, I think you'll have a really good foundation for managing and investing that money you'll eventually be earning -- not to mention building your long-term financial independence."
"We do appreciate your spending this time with us, Grandpa," replied Kevin. "But we'll remember these Saturdays even more fondly once we become millionaires!"
"You certainly don't lose sight of your objective, Kevin! And by the end of today's discussion, your understanding of mutual funds is almost certain to become a very important part of your future success in wealth-creation.
As we mentioned near the end of last Saturday's session, most of the investment options we've discussed so far can be purchased individually, or through some form of Mutual Fund."
A MUTUAL FUND is offered by a company that attracts many individual investors who wish to own stocks, bonds, or other securities, on a pooled basis. Each investor buys into the fund, purchasing shares or units, which represent his proportional investment.
BENEFITS OF MUTUAL FUNDS
- "Mutual funds are an investment vehicle. An investor can buy units (shares) of the fund on a one-time, or regular-contribution basis. The latter allows over time, for automatic averaging of unit-costs, thereby smoothing out the bumpy effect of major market changes.
- They are instruments of easy diversification, allowing individuals to own a share in a basket of investments in any category of their choice. This averages the investor's risk across many products.
- They are easy to invest in, providing opportunity for achieving easy balance between equities, bonds and other fixed-income investments.
- They are easily convertible on short notice, into cash.
- Over the long-term, consistent investment in solid mutual funds should produce a significant, cumulative return. This helps the investor achieve his wealth-creation objectives."
TYPES OF MUTUAL FUNDS
"Mutual funds fall into two basic categories:
- Actively-Managed Funds
- Passively-Managed Funds
It's extremely important, before choosing a mutual fund for his portfolio, that an investor understand the differences between these two types of funds."
1. Actively-Managed Mutual Funds
An ACTIVELY-MANAGED MUTUAL FUND is one in which its managers make many individual decisions to buy or sell specific investment products, in an effort to outperform a particular benchmark index.
"These funds are operated by an investment firm or bank. It raises money from individuals and invests the proceeds in a particular group of assets, in accordance with a stated set of objectives, which it shares with its investors.
Each fund will purchase various investment products such as stocks, bonds and money-market instruments, depending on the fund's objectives. They can focus on various sectors such as mining or financials, or on individual countries or regions.
Many actively-managed mutual funds require a minimum initial investment.
Because of its active portfolio management, each fund charges an annual fee, called the Management Expense Ratio (MER).
Many funds also charge:
- An entry fee (Front-End Load Funds) or,
- An early-exit fee (Back-End Load Funds).
The disadvantages of actively-managed mutual funds are their high fees, and very spotty performance relative to index benchmarks, such as the overall S&P TSX Index, or many of its sub-indexes, such as the Resources or Financial Index."
2. Passively-Managed Mutual Funds
PASSIVELY-MANAGED MUTUAL FUNDS simply strive to track, rather than exceed, the performance of a particular index or sub-index.
"There are two main avenues for acquiring passively-managed mutual funds. They can be bought either as:
- Index funds, or
- Exchange-traded funds (ETFs)."
a) Index Funds
An INDEX FUND is a passively-managed mutual fund that strives to mirror the performance of a specific index such as the S&P 500 (broad-based U.S. Stock market index) or TSX 60 (top 60 companies on the Toronto Stock Exchange).
"As of 2009, index funds in Canada are offered primarily by Banks.
Index funds enjoy exactly the same advantages as actively-managed mutual funds, but with much lower management fees.
Since portfolio decisions are relatively automatic, and transactions infrequent, costs incurred by the fund are lower. As a result, the fees charged to investors are dramatically less than those of actively-managed mutual funds."
b) Exchange-Traded Funds
An EXCHANGE-TRADED FUND is very similar to an Index Fund. It also tracks a specific index. It is however, bought and sold like a stock.
"Even fewer decisions are required of the fund manager, since the index is tracked relatively automatically. Fees as a result, are even lower than those levied for Index Funds."
"So, Grandpa," clarified Jenny, "do I hear you saying the main difference between an index fund and an exchange-traded fund is basically the way you buy and sell them?"
"That's generally correct, Jenny. But as I'll explain in a minute, there are nevertheless good reasons for choosing one over the other."
"Grandpa, in comparison to the individual investments we discussed, how risky are all these different types of mutual funds?" asked Kevin.
"Well, Kevin, it depends on the specific products in which a particular fund invests:
- Clearly, if a mutual fund is invested in a diverse basket of fixed-income products, it will be very safe.
- If the investment is in equity-based products, then due to the inherent volatility of stock markets, the risk will be greater, especially over the short term. On the other hand, particularly over a longer period of time, equity-based mutual funds will have a much greater upside.
Because mutual funds by their very definition contain a broad basket of individual investments, the diversification factor makes any type of mutual fund less risky and less volatile, than if you were to invest in specific stocks or bonds.
The real challenge for the investor is to invest in funds:
- With a low cost-base; and
- Which strike the right balance between fixed-income and equity-based products.
With this careful balance, such a portfolio will often be referred to as a balanced portfolio."
"It seems to me," suggested Jenny, "that what's important is whether the actively-managed mutual funds do well enough to make up for their higher fees, compared to how Index and Exchange-Traded Funds do, with their much lower fees. Right?"
"Absolutely correct, Jenny.
Remember our reference to the TSX Index performance over the years 1940 to 2007? Over that period, we saw that the Index increased by an average, compounded annual rate of 10.6%.
Many of today's financial products such as Index Funds and Exchange-Traded Funds did not exist decades ago.
But if, using products available today, and over that same time span, you had been invested in the TSX Index through either of these passively-managed funds, you would have netted an annual return of at least 10.1%, because the average management fees would have been no more than about 0.5%.
Now, let's assume the same 10.6% rate-of-return over the same 67 years. But this time the investment is in an actively-managed mutual fund. The actual yield to the investor would have had to be reduced by management fees of some 2.5%. This would have resulted in a much lower net annual return to the investor of only 8.1%.
The 2.5% figure represents approximately, the average annual Canadian Management Expense Ratio (MER) of actively-managed mutual funds. If the fund had also had a front-end load cost, the yield to the investor would have been even less than 8.1%.
In this example, with both types of funds performing equally, the net return to the investor of the actively-managed fund would have been at least 2% less on an annual basis, than if he were invested in the low-cost, passively-managed fund."
"I remember in our earlier discussion, when you showed us the incredibly negative effect of a 2% greater annual cost on our friend Sam's investment returns," recalled Kevin.
"This is so important, Kevin and Jenny. Because of these much higher fees, actively-managed mutual funds represent a higher level of risk to your investment returns than does either a passively-managed index fund or an exchange-traded fund."
"Charging the same high fee, whether the actively-managed mutual fund goes up or down in value, doesn't seem fair," offered Jenny. "Why would the cost be the same to the investor if the fund has a bad year?"
"Well, Jenny, the fund management's argument is that their costs continue at the same level, whether a fund is up, down, or unchanged in value. To be fair, the same also holds true for index funds and exchange-traded funds. At about 2.5% however, the average MER of an actively-managed mutual fund is about five times the approximate average of 0.5% charged by index funds and ETFs."
"I'm glad we don't need to write a test on all this," commented Kevin. "It's a pretty convoluted subject, even for someone like me who enjoys math problems."
"This subject can take some time to digest. I've been at it for decades and there's always something new to learn.
It may become more clear as we look at the specific performance of actively-managed funds, compared to that of passively-managed funds.
It makes sense that an investor would not mind paying higher fees for an actively-managed fund, if its long-term performance were to more than compensate for the higher fees.
Let's consider that next, as we compare the relative performance of these two categories of funds.
But first, a short break?"
"Yes, yes, yes!"
TIP #70..... A successful investment portfolio will often include in its investment mix, well-managed mutual funds with good track records. However, great care must be exercised to properly consider each fund's performance for the investor, after the impact of all costs: Front-End Load (entry) and Back-End Load (early-exit) charges, as well as annual Management Expense Ratio (MER) fees.
"Peter Dolezal's newest book oozes credibility, and provides a practical insight into how to create and sustain wealth. Especially useful for young adults, this book should be mandatory reading for all high school and post-secondary students. A must read for all Canadians."
--Bob Skene, FCA, Past Chairman, Chancellor and President, Royal Roads University
UNIQUELY CANADIAN -- A PRACTICAL STEP-BY-STEP GUIDE TO WEALTH-CREATION
Click HERE to buy the book!