Be your own investment manager Part 5: Mutual Funds

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By Ed

One of the big questions my students ask me every semester when we talk investing is, "What do you invest in?" or "Would you invest in _______________ (insert name of hot-company-of-the-moment here)?".

My answers vary and since I want to get them to think for themselves, I usually turn the questions back on them.  For the purposes of this discussion, you'll probably want more specifics and less Socrates.  While there isn't one perfect investment, I'll try to cover some filtering strategies for one of the most popular: Mutual Funds.

Last week I talked about the two big variables in any investment - Risk and Return.   I had also mentioned that this week I planned to talk about some possible investments on each level of the Investment Pyramid and my take on them.

I got to writing and realized that this week was just going to be about Mutual Funds, so I hope you aren't too disappointed.  I will get back to the investment pyramid (triangle) next week, but all the stuff I was going to say really depends on a good understanding of Mutual Funds. So here we go.

Mutual Funds: What are they?

If you don't know, don't be ashamed. Many people who invest in them do not really understand what they are.  I wonder why that could be?  In Canada, there are only 179 Companies that manage Mutual Funds.  Pick a company at random from that list and they will probably have at least 2 or 3 Funds to choose from and some (Fidelity for example) have hundreds.

All told, you are faced with thousands of Mutual Fund Options, each with names like the "Bissett Canadian Short Term Bond Yield Class A" (actual name).  To top it off, you can go to a Mutual Fund Dealer (someone who sells Mutual Funds that other people are managing) and be faced with nearly all those options under one roof.

Confused yet?

So here is my Mutual Fund explanation. 
You want to invest, but you don't have enough money to buy a share of Google (currently trading around $1000 a share) much less diversify your investments.  Diversifying is simply that old standard "Don't put all your eggs in one basket": spreading your investments around to spread out your risk.  But with only $25 to invest, you won't be able to diversify much, will you?

Enter the Mutual Fund.  You and a bunch of like-minded people who want to invest, diversify and each has only, say, $25, mutually pool your money into a fund.  You then get an investment professional to invest that money for you into investments that meet your goals.

You pay that investment manager a fee (typically a percentage of all the money invested) for their investing genius.  Your $25 (which wouldn't buy you even 1 share of Google stock before) now can buy you part ownership in dozens or perhaps hundreds of investments when pooled with all the other investors.

Sounds good, right?  

Generally, it is.  Mutual Funds are likely the single easiest way for most of us to access any type of investment out there.  From high tech stocks in Mumbai to low-risk government T-bills, you can find a mutual fund that targets nearly any sector or asset class.  They can be started for modest amounts of money and give you diversification.

But there is a catch.

The Professional Management is a double edge sword - you pay that fee whether or not your fund earns a return or loses money.

Many have "Loads" - another type of fee you pay for the privilege of Getting In (Front End Load - like a gym's 'Initiation Fee") or Getting Out (Back End Loads - like, ummmm, the Mafia making you pay them to get your money back).

And the dirtiest secret of all - those professionals you're paying a cut to may not actually be that good.  In fact, many professional managers cannot earn you a better return than you could earn through an Index Fund, but more on that later.

So, how can you differentiate a good fund from a bad one? First off, be sure you are looking at the right type of fund to meet your investment goals and risk tolerance (remember, the tradeoff for growth is higher risk).  But beyond that, here are some "dating tips" to help you have a romantic time with your mutual fund.

  • Look for a Fund with at least 5 (but ideally 10 or more) years of history. 
 Mutual Funds have been around for a while now, so you should be able to see historical returns for at least 5 years.  If your fund can't show a past, there may be a reason.

Mutual Fund Companies kill under-performing funds (or "Roll them into new funds with new names") as really lousy returns don't sell well.  

If you open the Investing section of a newspaper, you will likely see a Mutual Fund trumpeting 200% return or something like that.  Read the fine print - that return is likely from a very small time period in that fund's short life - probably 1-6 months, tops.  

Anyone can get lucky and flip heads 2 or 3 times in a row.  Averages tend to, well, average out over time, and odds are that 200% return will come back to earth soon - probably after you buy in.  Give me an average performer for 10 years over a 3-month superstar anyway.  Keep in mind, you are in this for the long haul.

  • Compare your fund to an appropriate Benchmark.  
I ask kids in my classes, "What are some things you can tell your parents if you do poorly in a class - let's say get a mark 10% below your normal grade average?".  

They usually offer several different excuses, but someone eventually comes up with "Look at the class average in the course I did badly in".  If you got a 65%, but the class was a really hard one with a class average of 60%, your parents might be OK with it.  More OK at least.  

Mutual Funds are the same.  It is very hard to win all the time.  Sometimes the best you can ask of your Mutual Fund is to not lose any worse than the average.  All Mutual Funds have Averages or Indexes you can compare them to.  The Globe and Mail's Fund Monitor offers side by side return comparisons for hundreds of Canadian Mutual Funds and their appropriate benchmarks for all years they have been trading.  If your Fund can't keep up with the "class average", don't hire a tutor, just get out.

  • Know your Management Expense Ratio (MER).  
Firstly, find a No-Load fund.  I know mutual fund salespeople can give me good reasons why "Loads" benefit clients (something like "Back End Loads deter you from taking your money out in down markets and taking a beating on the investment"), but those reasons are typically financial incentives for salespeople to keep people invested rather than educate them on why they should stay invested.  

Once you have your no-load fund, look at the MER.  It will be a percentage figure typically between 0.5% and 3%.  Because they are such small percentages, they are often overlooked, but since you will be investing for the long haul, it will compound over time and eat away at your return.  

I think you should be trying to find a fund with an MER around 1%.  Again, compare it to other, similar funds out there and look at the trade off between higher MERs and higher return.  If two funds offer similar returns, use MER as the tie-breaker.  Totally avoid funds that have low returns and high MERs.

(image source)

  • Don't diversify your Mutual Funds too much.  
Pick your Growth Fund, your Security Fund and maybe one other, based on your goals and risk tolerance.  Mutual Funds are already diversified and the fact is that Canada is a small country with very few (relatively speaking) big companies that funds can invest in.  

Buying 3-4 Canadian Stock Funds probably means you are paying 3-4 management fees to separate Fund Companies to buy shares in (probably) the exact same group of businesses.  If you do your research when picking your Fund and it looks good, put your eggs in that one basket and watch it. (apologies to Mark Twain).

So, to sum up, the balancing act for Judging a Mutual Fund looks a little like this:
  1. Narrow the list to type of fund you are looking for (Return, Income, Cash Security).  
  2. Narrow that list to funds with at least 5 or more years of return history.  
  3. Narrow that list further by getting rid of funds that can't keep up with their benchmarks.  
  4. Finally, find the lowest Management Expense Ratio of the funds that remain (1% target).  

Easy right?  Not falling-off-a-log-easy, but I hope you can now bamboozle your bank investment adviser with a few "industry words" and make them jump through some hoops to earn your business.

So what do I invest in?  Look at the list I went through above and imagine a fund that has decades of history, never loses to its benchmark and has an MER that is sub-1%.  That sort of investment would be attractive, right?  It exists and I will elaborate on it next time when I finally get around to breaking down the levels in the Investment Pyramid.

Keep reading...

 The "Be Your Own Investment Manager" Series:

Part 1: Best Time to Start
Part 2: How Much and How Often to Invest
Part 3: Invest in Your Debt?
Part 4: Risk and Return
Part 5: Mutual Funds
Part 6: Simple Investment Options
Part 7: Saving for Retirement (RRSPs)
Part 8: The Colour and Psychology of Money
Part 9: Saving for Education

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