By: Mark Seed (If you’d like to contribute to CBB please contact me.)
GET PERSONAL WITH YOUR INVESTMENTS SO YOU KNOW EVERYTHING
Over the last few months, I’ve received a few emails from readers that go like this…
I’ve been with my investment company for over 10 years now. I’d like to stay with them because I like them but I keep hearing that high fund fees are bad for your portfolio. Is that true? Should I switch? If so to what?
I like your blog a lot and I’m envious about how you managed to get out of your high-cost mutual funds into low-cost Exchange Traded Funds and some stock investing. Where do I start? What should I think about?
Readers, I sense your frustration. I’ve been there so I know how you feel. I feel my biggest investing mistake to date was investing in pricey mutual funds for far too long.
Insanity: doing the same thing over and over and expecting different results – Albert Einstein.
Today’s post will share my background in investing, why pricey mutual funds will hurt your portfolio and what you can do about it.
My background and mutual funds 101
Throughout my 20s and into my 30s, I invested in big bank mutual funds to grow my retirement portfolio. I recall the performance of those funds did moderately well throughout that time but on the cusp on the 2008-2009 financial crisis is when I really started to take notice of what these funds invested in, how they were performing relative to their benchmark, and mostly importantly, what fees I was paying.
For decades, equity mutual funds have been a hugely popular way for Joe or Jane Canadian to own pieces of companies. It’s easy to see why people use them:
- Mutual funds pool investor money and therefore provide diversification. Many people don’t have the cash to invest individually in a large number of companies so a mutual fund allows investors to own positions in a bunch of companies. If a few of these companies don’t do well, no problem, the rest in the fund should offset poor performers.
- Mutual funds provide professional money management services. Many people don’t have the time, energy or desire to research stocks, when to buy those stocks, what accounts to hold those stocks, so professionally managed money helps people in this regard.
- Mutual funds provide liquidity. Units of mutual funds can be easily bought and sold.
- Some mutual funds can be inexpensive to buy. No-load mutual funds exist. This means these funds don’t charge any fees to buy or sell units but they do have operating expenses, as you’ll read about soon. This means not all mutual funds are created equal.
So, there are a few different types of mutual funds you should be aware of:
Money Market Funds
These types of funds invest primarily in treasury bills and other high quality, low risk short-term investments. They are designed to offer stability and minimal risk, so given their low risk you’ll likely get very low return, usually in the form of regular monthly distributions.
Fixed Income Funds
By investing in fixed income securities such as mortgages, bonds and preferred shares, fixed income funds offer regular cash flow while preserving capital. Depending upon your risk tolerance, these funds are usually a good way to diversify (from equities).
Balanced Funds / Planned Portfolios
Balanced funds hold a combination of equities, fixed income and money market investments. These may also be planned portfolios. Investors will receive distributions usually in form of interest, dividends and capital gains from these funds.
These funds invest in the stocks of publicly traded companies. These companies may be from Canada, the U.S. and around the world. These funds allow investors to take on more risk; and more risk can provide growth potential over the long-term.
I could go on about the merits and into more details about the types of mutual funds available, and while there are some great mutual fund products on the market, there are no high-cost mutual funds you should own for your portfolio – at least this is my opinion. This is because the money you pay in money management fees is the money you never keep you yourself. Let me say that again: what you pay in fees, is money you don’t keep.
Types of fees and what that means to you
This is largely why I left the mutual fund industry. Given the alternatives available to me, and based on our new found financial plan devised during the 2008-2009 financial crisis, my wife and I made the decision to ditch pricey mutual funds.
What price was I paying in fees you might ask? I was spending at least 2% of our hard earned money on fees. This is money I would never see again.
If you don’t already know what you’re paying, here is a primer of what you might be forking over and what you should find out:
- Front-end charges. These are fees to buy the funds in the first place. Basically, you’re paying to get into the mutual fund game. Some funds have historically charged up to 7% for this – that’s $700 for every $10,000 invested folks! I never paid this much (7%) but I did pay 3% once for one mutual fund product.
- Back-end charges. These are fees to sell what you own. Variations of this may be called exit or redemption fees or deferred sales charges (DSCs). Basically, you’re paying to get out of the game. These fees usually correlate to the amount invested. They’re usually charged based on a sliding scale that disappears over time. For example, there may be a 5% back-end DSC. In the first year to sell fund units, that 5% will apply but it could be reduced over time, as per the fund fee schedule, by 1% each year. Thus, if a fund is held more than five years, there could be no fee to sell.
- Expense fees. These are fees to cover operating expenses, to pay fund managers and to cover the transactions to buy and sell fund units. Operating fees and management expense ratios (MERs) can range dramatically. If you don’t know what the MER is for any of your mutual funds – ASK!
I’ve covered some of my investing background and shared a few reasons why I left the mutual fund industry. But there are other BIG reasons to consider ditching your pricey mutual funds. Thanks to some financial mentors, and some of my own inspiration to read many investing books after the financial crisis, I learned high fees are putting you at a major disadvantage to earning stock market-like returns. This is because academic research has signaled many times over:
- The gross returns (that means before expenses) obtained by all money managers are in aggregate the market’s return,
- The average net return (that means after expenses) to investors is the market return minus the expenses of active stock selection, transaction costs, taxation and other expenses, which means,
- Money managers, charging investors 1%, 2% in my past life, or even 3% in extreme cases, must beat the market every year over and above those fees charged for as long as the fund survives just to keep up with the market’s returns.
In essence: 1) most professionally managed money is at a massive disadvantage to the market’s returns and to compound this issue 2) there is virtually no academic evidence to suggest anyone, including highly paid professional money managers, can predict what the market will or won’t do over time.
Crap. That sucks.
So I just told you’re probably paying lots of money management fees, likely to under-perform the market over time AND nobody has any idea what the financial future will bring.
Where the heck does that leave you?
Well, it has been said there are two kinds of investors: those who don’t know where the market is going (and can admit it) and those who don’t know that they don’t know (and can’t admit it). Now that I have you in camp #1 there are choices my friends, and the last part of this post will suggest some for you.
I need to ditch my pricey mutual funds, now what?
First, I think regardless how nice your investment or bank financial advisor is, ask about your mutual fund fee structure and figure out what you’re paying in money management fees, and get it in writing. A blunt talk to come I know but something that is essential: because you can’t act on what you don’t know.
Second, now that you know what you’re spending in money management fees, and you recognize that keeping fees low/lower is important for investing success, consider what your alternatives might be.
- Are you willing to stay with the same company, just different financial products including other lower-cost funds?
- Are you willing to become more active in your financial affairs – say open up a discount brokerage account for DIY investing?
- Are you willing to open up your brokerage account, but wish to work with a fee-based advisor?
- Have you heard of robo-advisors?
Take some downtime to read, learn and ask lots of questions to figure this out. This relates to my next point.
Third, consider how investing in general, whether that’s mutual funds, Exchange Traded Funds (ETFs), stocks, bonds, GICs or anything else for that matter – fits within your financial plan.Maybe I should have put this point first. I say that because I’m a big believer in plans before products.
I believe you need to know what you’re saving for, first, why you are saving, before you actually figure out the products to help you invest. Savings for short-term expenses like buying a new car, a down payment for a home, fixing the house; should probably be out the market and not really invested per se.
This means this money is likely kept in cash and readily available in a high-interest savings account for the next 2-5 years, or whatever you are saving for. Alternatively if you’re saving money for retirement purposes, and your timeline is >5 years then consider a mixture of stocks and bonds for longer-term growth.
I personally invest using what I call a ‘hybrid’ approach – investing in dividend paying stocks that generate income and a couple of low-cost, broad market ETFs for growth. That decision was based on our risk tolerance and financial plan. In the end it’s your financial future, so you need to have your plan – that’s where the process of planning comes first before products.
To wrap up folks, I think mutual funds in general have an important place in our financial industry; I listed those benefits above. I’m not against mutual funds at all, I’m just against the very expensive mutual fund variety – because the money you pay in fees you don’t keep for yourself and because of those high fees and lack of a crystal ball – you probably won’t match stock market returns over time.
A smart investor is a knowledgeable investor. Your financial knowledge starts with understanding what money management fees you’re paying for the financial products you own and how fees can impact your portfolio returns over time. Get out there, get asking some important questions – ditch the pricey funds – and get informed.
Learn, save, invest and prosper, and thanks for reading.
Mark Seed is passionate about personal finance and investing and is the blogger behind My Own Advisor. Mark is currently investing in dividend paying stocks and ETFs. He is almost halfway to his goal of earning $30,000 per year in dividend income for an early retirement. You can follow Mark on his path to financial freedom here.
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