The Benefits and Drawbacks of Mutual Funds

High management fees, unexpected costs to sell funds, and high pressure sales tactics have made many investors wary of purchasing mutual funds. But like any investment type, there are pros and cons to adding funds to your portfolio. Mutual funds don’t just let you buy a piece of the equity market. You can use them to hold a variety of assets. There is merit in examining the benefits of mutual funds and in deciding how to evaluate which funds you might want to get.

Benefits of Investing Using Mutual Funds


Ability to Hold Expensive or Awkward Assets

Mutual funds may give you a chance to invest in an asset you couldn’t afford to otherwise purchase. For example, a share (yes one) in Berkshire Hathaway costs $151, 579 $168 900 US today [in February 2014]. In fact, it’s up $1079 2000 US in 2 days so far today, so you may want to hurry and get yours before the price runs away from you. A share of Apple is a much more affordable $449 529. Why not go buy a few board lots?

There are mutual funds that hold both Apple and Berkshire Hathaway. (One available only to Americans is Matthew25, MXXVX.) Most of these funds cost about $25-100 per unit. That makes buying a share of the value of expensive assets achievable even for investors without million dollar cash balances.

Mutual funds also can let you invest in awkward assets like precious metals. Owning physical gold, silver and platinum requires having a safe storage spot. It may also be difficult to re-sell your holdings quickly if you change your plans. Buying precious metals through a mutual fund like the BMG Bullion fund (BMG 100) that holds real physical metals for you in secure storage might be preferable.

Expert Knowledge

I know that it sounds hokey but it is true that most of the better mutual funds have a very knowledgeable manager in charge of the money. If you have zero interest in learning about business and finance there is value in paying someone else to provide you with that service.

Two caveats:

  1. True index funds do not rely on any expert knowledge. They just mimic an index. Don’t pay for expert advice if you’re not getting any! A true index fund should have a very low MER (fee.)
  2. Most ETFs are managed by experts who are just as knowledgeable as mutual fund experts. The fee you pay for their expertise, however, may be lower. Check the fees and MERs to compare similar ETFs and funds.

Low Entry Price and Low Minimum Purchases

Many mutual funds are inexpensive on a per unit basis. That allows investors to get started while they are still building up their savings. Many banks, for example, only require $500 to start investing in a mutual fund. The ING Direct Streetwise funds have no minimum investment. If you had $10.13 $11.61 you could buy one unit of their Streetwise Balanced Growth Portfolio right now.

Often No Fee to Purchase or Sell

To buy or sell equities and most ETFs you have to pay a fee called a trading commission. Many mutual funds can be bought and sold without paying any trading commission. This includes funds purchased directly from the issuer, like a bank, and funds purchased through an online brokerage.

Be aware, though, that some funds charge a fee if they are sold within a certain time after they were purchased. For example, many mutual funds charge a fee if sold within 90 days of the purchase.

Active management, If Desired

If you like the idea of having a person actively managing your investment, there are many mutual funds that are actively guided by a manager. For example, that manager may be making daily or monthly decisions about whether to purchase or sell specific equities held by the fund. In theory, a good manager may spot valuable assets trading at a discount and buy them to gain that extra value.

Index coverage, if Desired

If you prefer a Couch Potato investing strategy, there are mutual funds that do not have any active management. Instead, the fund buys and holds the same investments as the index after which it is modelled. This type of fund should charge less for management fees.

Dollar Cost Averaging

This is one of those theories that sounds good but doesn’t always seem to make much difference in the real world. Anyway, the theory is that if you buy a certain fixed amount of an investment at intervals, over time you will buy some when the price is high and some when the price is low. That should result in better earnings than if you accidentally bought it all when the price was high. (It will actually result in less profit than buying it all when the price is low.) So for example, if you buy $50 worth of a mutual fund every month you are less likely to buy all your units when the price is high.

This was a concept dating back to The Wealthy Barber. I don’t know if it’s still being quoted much or not!

One real advantage of dollar cost averaging is that it stops analysis paralysis. Instead of dithering and never investing for fear of buying high, the investor goes ahead and buys.

Diversification

Obviously if you spend $50 to buy one share of one company you are not going to have as diversified an investment account as if you spend $50 to buy a small share of 100 companies held by a mutual fund. If you believe that diversification is important for equity investing, mutual funds can make it easy.

Diversity can also refer to types of assets. You can diversify your portfolio by buying units in a bond fund, an equity fund, and a gold bullion fund. This will give you several types of assets even if you have a small total dollar value portfolio.

Tool to Purchase Bonds Efficiently

A bond fund manager will invests in a selection of bonds. They may be government-issued bonds, corporate bonds, or municipal bonds. They may have terms to maturity of 1-50 years. The fund manager can negotiate lower fees for volume purchases. The PH&N Total Return Bond Fund https://www.phn.com/Default.aspx?tabid=887 is an example of a bond fund.

Buying units in a bond fund requires less capital investment for more diversification with lower purchase commissions and active management. What’s not to like?

Drawbacks of Investing Using Mutual Funds

Front End and Back End Loads

Some bond funds charge a fee to purchase the fund. It is sometimes called a Front End load. If, for example, you have $1000 to invest in a fund, they may take a $100 fee for purchasing the load. That is a 10% load. You may not notice the fee, though. If they just tell you that $1000 will buy you 47.98 units, do you really know you should have got more units if there was no fee? Always check whether there is any fee, charge or commission for buying a fund.

You can probably guess a Back End Load is charged when you sell a mutual fund. Often this load decreases the longer you hold a fund. It may even reduce to zero after several years. Why do the fund issuers set up these kind of declining loads? It allows them to say the back end load is to reduce the number of people jumping in and out of the fund. I suppose it does. But they don’t say it also deters people from selling even when they know they should. People hate to pay a fee especially to sell a fund that has already lost them money. Try to avoid all Back End Loads, even declining ones.

These fees can also be called Deferred Service Charges or Declining Service Charges.
In most cases, the funds you want are called “no load” funds. Only if a mutual fund offers amazing benefits should you consider paying a load.

Management Expense Ratios (MERs) May be High

Most of the fees you pay to own a mutual fund are bundled up in something called the MER. The MER usually includes any payment made to the fund manager and staff, any commissions charged to the fund when it bought and sold investments, legal fees, accounting fees and any payments made to the bank or financial advisor who sold the fund to you. That’s right: for many funds you pay a fee each year to the person who sold it to you. It’s called a trailer fee. Why did you think they were so eager to sell you a mutual fund and not a GIC?

The MER is expressed as a ratio, or commonly as a percentage of the fund per year. For example, many Canadian funds charge a MER of 2% per year. That means that 2% of the fund’s value is paid to cover expenses each year. In theory, the fund should also have income. The 2% cost is deducted from the income. The difference is what is reported as the fund’s return for the year. So if the fund earned 10% income and had a 2% MER you’d see the fund reporting an 8% annual return for the year.

What happens, though, if the fund does not have any income for the year? Then the 2% MER comes out of the capital invested in the fund. So a MER can actually make a fund suffer a loss! And if a fund is having a really bad year and has already lost 15% of its value due to, say, a stock market crash, then the MER will exacerbate the problem. In that case, if the MER is 2%, the annual return for that fund will be -17%.

That’s right, in a year when your mutual fund has lost money, the advisor who sold you the fund still gets paid, and the fund manager still gets paid, but you don’t.

ETFs also charge MERs but they are often lower than mutual fund MERs. You have to watch this closely though as it’s not always true. And some funds, like some of the TD Waterhouse e-funds have very low MERs.

Minimum Holding Periods

Many mutual funds require you to stay invested for a minimum period of time, often 90 days. If you sell before then, you will be charged a fee. The fee can be quite high. Be sure to check for minimum holding periods before purchasing a fund.

High Initial Investment

Many well-respected funds have a high initial investment requirement. They can demand $5000 or more per fund or per fund issuer to start.

High Pressure Sales Tactics

Unfortunately, the buying process can be made very uncomfortable due to financial institutions using high pressure sales tactics. You may go in just wanting to invest in a GIC and end up buying a mutual fund instead. Try to have a plan before visiting a bank branch or financial advisor’s office. Take a friend or relative for moral support who can insist you leave the meeting if you seem harassed.

Over Diversification

No one needs a dozen mutual funds. If you think equity diversification is very important to you buy a fund that covers the entire TSX, a fund the covers the entire US NYSE, and a fund that has lots of holdings outside of Canada and the US. To diversify your types of investments, add a bond fund and a gold fund and you’re done. That’s 5 funds.

You can simplify even further by buying a good balanced fund that holds equities, bonds and precious metals.

Readers may remember me mentioning once before about a mutual fund plan that we purchased while under the influence of high pressure tactics many years ago. It held not one, not two, but 4 bond funds, 2 money market funds, and 4 equity funds. It was absolutely ridiculous but this was the “standard” package being recommended to low-risk-tolerance investors by one of the Big 5 banks. Buyer beware!

Conclusions
The benefits of buying mutual funds include allowing efficient investment in bonds and bullion. For a low initial investment a buyer can build a portfolio of no load low MER funds that offer index mimicking or active management of equity investments. Unlike most ETFs, there is usually no fee to purchase or sell mutual funds. Many mutual funds also allow complete reinvestment of dividends and income in additional units, including fractional units.

Many of these benefits are also offered by investing in ETFs.

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