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How to Evaluate Mutual Funds and Choose which Funds to Buy

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OK, I’ll admit my past investments in mutual funds are good examples of how NOT to evaluate and choose which funds to buy. However, by investing unwisely I have learned a few lessons that I will share with readers. I also encourage you to share your own mutual fund buying experiences, good or painful, with a comment. There’s always more to learn! This article describes some methods to help evaluate a mutual funds’ risk and performance before choosing which fund you want to buy.

Remember, while reading, that mutual funds are not only for investing in the stock market. They are great tools for investing in bonds, bullion and other types of assets. For more details, please skim The Types of Mutual Funds, Why They’re Good, and Quick Buying Tips.

Evaluating Mutual Funds

Take a Quick Look by Starting with the Fund Facts Sheets

Fund Facts are Your “Friend”

I’m never sure I trust employees of the government or of a financial institution when they say they want to be my friend. I mean it’s nice but I’m always a bit suspicious. I feel the same way about the required Fund Facts sheets provided by mutual fund issuers. It does provide a lot of useful information in a consistent format and in fairly readable English. However, I wouldn’t rely solely on the Fund Facts sheet when deciding whether to invest in a fund.

What Does the Fund Facts Sheet Identify?

Performance History
How did the fund fare in 2002 and 2008? The stock market as a whole did poorly those years. The TSX Composite fell about 35%. The S&P 500 in the US dropped about 32%. Bond and precious metals funds should have shown reasonably good results those years as investors fled from stocks into perceived security. Did the fund do better or worse than the market average?

Investments
The Fund Facts sheet should list the top investments of the fund and describe the types of investments held by the fund.

This can be a very important section to review!

For example, you might think a fund called the BMO Canadian Equity Class Series A Fund would be invested in Canadian Equities, right? Yet in the description of “What does the fund invest in?” BMO states “The fund may invest up to 30% of the purchase cost of the fund’s assets in foreign securities.” In other words, the fund could go and buy stocks in, say, businesses in Greece and Spain if it wanted to. Canadian, eh?

Costs
The costs section includes the cost to buy the fund including any commissions or fees. It also includes the ongoing costs of owning the fund including the MER and whether the MER pays trailer fees. (Trailer fees are often annual and are paid to the person who sold you the fund for as long as you hold the fund.) If there is a fee to sell the fund (called a deferred service charge or a declining sales charge) it should be reported here, too.

Risk
The sheet gives an approximation on a scale of 1 to 5 for how risky an investment in the fund is.

The problem is there is quite a difference between what the industry considers risky (hedging; options; leveraged investing; penny stocks) and what most investors like me consider risky (losing 20% of the funds value if the market sways). I think you shouldn’t put too much faith in this chart as I think most stock funds are going to be listed as “medium” risk.

Ellen Roseman of the Toronto Star wrote a great article on this called “Is a fund that drops 60% only ‘medium’ risk?”

Get Under the Hood: Look at the Core Holdings

The names of mutual funds often seem to have been selected by a random phrase generator pre-loaded with words like “performance; high; income; dividend; yield; growth; security; guaranteed“ The names often don’t actually reflect what is held by the fund. The only way to know what you’re really buying a share of is to look at the holdings of the mutual fund.

For Canadian funds, the top holdings are usually easy to find in the Fund Facts summary for the product.

Be Careful because Fund Names Don’t Match Fund Holdings
For example, the RBC Global Dividend Growth Fund Series A is actually invested 63% in American equities. [UPDATE: In February 2014 it was down to 35.6%.]  If you bought this fund assuming it was investing primarily outside of North America you’d be wrong. Look at the details, not at the name.

In another example, the RBC Asian Equity Fund Series A is 15% invested in Australia. [Update: In February 2014, still 14.1% in Australia.] Now I don’t know for sure what they teach now, but when I went to school Australia was NOT part of Asia. Names can be misleading.

How Will You Make Money from the Mutual Fund?

One thing I didn’t consider well enough before buying a mutual fund was how I would make money from owning that fund. I was used to funds that paid distributions that were re-invested as additional units. I honestly didn’t look closely at that aspect of this fund before I bought it.

The fund, like many of my investments, promptly tanked as the price of oil halved. I sighed. The oil patch and I have a long history and I knew that given enough time and patience, petroleum stocks rebound. I’d just have to wait since I still considered the companies the fund was invested in were good choices for the long term.

Imagine my shock when I realized, though, that this particular fund is purely a capital gains play. It doesn’t make any distributions, ever. You buy it, wait till it appreciates in value, then sell it. The only money you make is the difference between your buy and sell prices.

I *hate* having money invested that shows no annual return. If a stock pays at least a small dividend, I feel better if I have to wait for a market rebound. With this fund I had to either sell and eat the capital loss or hold and lose the opportunity value of that money while I waited for a rebound (and hopefully an eventual uptick.)

I learned my lesson that time. I don’t buy anything now that doesn’t have some form of annual distribution. I’m just not wired to handle dead weight investing.

Look at the Fees and Commissions Including the MER

Almost all mutual funds have a Management Expense Ratio or MER. The MER tells you what percentage of the fund is used to pay costs each year. A typical MER might be anywhere from 0.35 to 2.5%. That’s quite a difference. It means you are paying $17.5 to $125 per year in fees to own $5000 of a fund.

In a good year, the MER is subtracted from the earnings of the fund before the profits are distributed to the fund owners. Profits may be distributed as income or as an increased value per unit of the fund or as an increased number of units in the fund.

In a bad year, however, the fund may lose money. then the MER is subtracted from the actual value of the fund. That’s right; you have to pay the MER even if the fund loses money.

If the markets go down and a fund loses 15% in value and the fund has a 2.5% MER, then the real loss passed on to the fund’s holders is 17.5%!

According to various studies, Canada has some of the highest MERs for mutual funds in the world. Check closely how much you would be paying before purchasing a fund.

Some companies offer funds with comparatively very low MERs. These include the TD e-series funds available only to investors with an online TD Canada Trust EasyWeb account or a TD Waterhouse Discount Brokerage account. (Vanguard is now offering some very low MER ETFs in Canada, too.)

Look at the Redemption Terms

For many mutual funds you are locked in to your purchase for 90 days. If you try to redeem (sell) your fund holdings before 90 days you may have to pay a very large fee. Check the prospectus for information on early redemption.

However, funds may have longer or shorter holding requirements. For example, at the time this was written, there was no minimum holding period required for the Renaissance High Interest Savings Account mutual fund, ATL5000. This fund is encouraging investors to “deposit” cash like in a daily interest savings account while waiting to invest elsewhere.

Look at the “Loads” Front End, Back End, Deferred Sales Charges or Declining Sales Charges

Some mutual funds still charge you a fee to buy them (a front load) or to sell them (a back end load or DSC.) It really should not be necessary to pay a fee just to buy or sell a mutual fund. Check whether there are any loads or DSCs and don’t buy if there are.

Look at the Trailer Fees for Mutual Funds

This fee is trickier to assess. A trailer fee is paid to the person who sold a mutual fund to a customer. The trailer is often paid annually for as long as that customer holds the fund.
This is not great, but it wouldn’t be so bad if the trailer fee was identical for every mutual fund. It’s not. Some funds pay larger trailer fees.

Now if you are the person who sells mutual funds and you could sell either of two funds and one will pay you 1% of the sale price per year forever, and the other will pay you 0.25% of the sale price for three years, which one will you naturally feel inclined to sell?

The problem is that as the customer we want to buy a fund with low or no trailer fees. So it’s up to us to check various fund choices and be aware that the salesperson might have a bias towards a fund with a higher trailer fee.

Ask yourself: who am I trying to make money for, myself or my salesperson?

Did you know that you pay trailer fees to your brokerage even if you have a self-directed brokerage account? That’s right, even though YOU are the person analyzing and recommending to yourself which mutual funds you should buy, you are paying your brokerage a trailer fee.  There have been a few attempts to change this but at most brokerages the practice stands.

Comparing Apples and Cows

Two funds may sound the same and have nothing in common. This is where it’s important, yet again, to look at what the fund is actually investing in.

For example, in early 2013, the BMO Monthly Income Fund is invested (at this time) 1% in cash and 51% in Canadian equities. The Fidelity Monthly Income Fund is invested 10% in cash, 24% in Canadian equities and 16% in foreign equities. Despite the very similar names they are not invested in comparable ways. Differences in their earnings could be due to differences in the risks they take and in the types of assets they hold.

Get Independent Advice Before Buying Mutual Funds

If you’re going to invest in mutual funds you should be looking for impartial, third party advice on which funds to buy. If you go to a bank, they are almost sure to only try to sell you their own line of mutual funds.

Where can you find impartial advice? For  years, Gordon Pape used to write an annual book comparing funds. He only made money from you buying the book whether or not you ever bought any funds. Now, his business runs an online newsletter called the Mutual Funds Update. (http://www.gordonpape.com/ )There are probably other newsletters out there too. Again, the newsletter publishers do not get a trailer fee because you don’t buy anything from them.

Other sources include reading financial newspapers and magazines.

You can also hire a fee-only financial planner. They get paid by the hour or project and do not receive any commission for what you purchase, because they do not actually sell it to you. It may be hard to find a fee-only planner, though, that is interested in helping clients with a low value portfolio.

When are Mutual Funds Worth Buying and Which Ones Should You Pick

Bond Funds

Buying units in a bond fund requires less capital investment for more diversification with lower purchase commissions than buying individual bonds yourself. It also provides active management. What’s not to like?

Compare the fees for ETFs vs mutual fund bond funds. Also compare the performance, though.

I’d take a close look at the PH&N bond funds, including their total return bond fund. There may be equally good bond funds out there elsewhere, too. I’m not an expert.

Disclosure:  I do own some holdings in a PH&N bond fund but it is not one available through discount brokerages only through company pension plans. And yes, in 2013 it lost money.

High Interest Savings Account Funds

The daily interest savings account mutual funds provide a convenient place to park cash in some discount brokerage accounts. For example, at CIBC Investor’s Edge you can put cash into ATL5000 with a minimum $1000 deposit. At other brokerages it isn’t as easy. For example at BMO InvestorLine there is a minimum deposit of $25,000! [UPDATE: As of April 11, 2013, BMO InvestorLine is offering a BMO HISA with a minimum deposit of $5,000.]

I have used ATL5000 at Investor’s Edge, RBF2010 at RBC Direct Investing and AAT770 DYN500 at InvestorLine successfully.

Precious Metals Funds

It’s difficult to buy and hold precious metals safely. If you want precious metals in your portfolio, it’s worth considering buying them through a mutual fund or ETF. Some funds like the BMG Bullion fund (BMG 100) hold real physical metals for you in secure storage.

Personally, I don’t own any precious metals and I have no idea in which fund it would be best to invest.

Index Funds

If I was investing in equities, I personally would choose a fund that matches a large comprehensive index, such as the TSX Composite for Canadian equities, the S&P500 for US Equities and something equally broad for other international equities. Any analysis of which fund to pick needs to look closely at the fees (especially the MER) and at the actual holdings to make sure it is replicating the index. You must compare the ETFs and the mutual funds to ensure you are getting the best options.

Remember, at many brokerages you will pay each time you purchase or sell an ETF, but you will not pay a commission to purchase or sell a mutual fund. You generally can also reinvest mutual fund distributions in fractional units, but you usually cannot hold fractional units of an ETF. Ideally you’d like to find a mutual fund that holds the same index as an ETF for the same or lesser MER. Then you could have the lowest fees and the best re-investment policy.

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Did you buy units in a fund that made you wealthy in weeks? Or did you “turn $1,000,000 into $10,000 in one easy step” (my personal specialty)? Please share your experiences with mutual funds with a comment.

RRSP Strategies Part 3: Keep it Safe to Start. Use Cash, Bonds, and GICs to Build Your RRSP Base

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Many investors aren’t going to want to read this, much less act on it, but I think the first thing you need in your RRSP is a safe base. This is the so-called fixed income or guaranteed part of your holdings. The money should be invested in boring, probably low-interest, (almost) totally safe options. These include cash, bonds, term deposits and GICs. For the really adventurous it could include money market funds and T bill funds. These are dull, predictable investments that you would likely be embarrassed to mention at a party. These are the investments, though, that will see you safely through many investing storms ahead.

How Much Money Needs to Be in the Safe Base for a RRSP Account?

Some of you are likely itching to get past the “safe” investments and move into the glitz and glamour of investing in stocks, options and hedging. You may be asking “How much do I have to have in ‘safe’ investments before I can move on?”

There is no right or wrong answer.

Personally, I would suggest having $25,000-$50,000 in safe investments before putting money into riskier ones. It’s very calming when the markets are bouncing around like lawn chairs in a flatbed truck on a washboarded road to know that a large chunk of your money is figuratively buried in the back yard perfectly safe and sound.

The gap between $25k and $50k yawns wide. How should you pick which side you need to stand on? Here are some factors to consider:

Do you have a maxed out TFSA? If so, how much is in it? How secure are the investments in it? If you have $31 000 $25,500 in cash and GICs in a TFSA (perhaps waiting to buy your next car or deal with any emergencies) then you probably only need $25,000 in safe investments in your RRSP before you lift the rope and cross into the deep end of the pool.
Also, how far from the shallow end are you planning to swim?

  • If you’re planning to invest in dividend-paying blue-chip stocks you can probably take those first strokes into the deep end while you have a fairly small safe base. Examples of the types of stocks I mean are shares in TD (a bank) or FTS (a utility company).
  • If you’re planning to try to pick individual stocks that will double in value in 6 months, you should have a substantial safe base. Examples of the types of stocks I mean are shares in BB (a high tech stock) or small aggressive oil and mining stocks.
  • If you’re planning to go for penny stocks, hedging, options, or leveraged investments you shouldn’t really be reading my blog. But if you are, consider having enough invested in total safety to buy you an annuity you can live on (at least spartanly) if all of your other investments fail.

Why is Losing Money by Investing Poorly When You Are Starting as an Investor So Serious?

The” You’re Young You Can Bounce Back from a Loss” Argument is Severely Flawed

So you are a new investor and you lost $2000. Why is that so bad? Yes, it hurts. But if you are a young new investor, you have many years to earn more money and hopefully make up the loss. That’s the logic used by many investment advisors who push their new clients towards high risk and volatile investments. (They’ll also push older new investors in the same direction but are a bit more wary of lawsuits.)

The problem is that many new investors who lose what feels like a lot of money will decide never to invest in that type of investment again. Ever. So if they buy a mutual fund that loses 40% of its value, they may never buy another mutual fund: not even an ultra-low-risk bond fund. And if they buy a stock that drops 25%, they may never invest in shares again. Even if they lost money on a hot tech stock they may refuse to buy even blue-chip dividend-paying stocks in the future.

Back when the dinosaurs roamed, I bought some index mutual funds in my RRSP. (There were no ETFs then.) They appeared to lose 25% of their value within the first 2 years. From then on I bought GICs for a very long time. Luckily I held on to the mutual funds. Eventually they evened out to earning about 7% a year over the long term. Still, it left me with a long-lasting reluctance to invest in the stock market, even by index investing.

Invest in Risk with Your Vacation Money Not Your Rent

One of my children was watching me update my financial spreadsheet with some dividend payments and capital gains one day. She was intrigued by the daily stock price chart shown on the brokerage account screen. So I stopped to let her really look at it.

“You know how you have money in the bank earning interest, right?” I asked. (She had it in one of the few accounts that actually paid interest: a 2% children’s savings account at ING Direct.) She nodded. “And you know you get $2 a year on every $100 in your account, right?” She didn’t but she nodded anyway.

“Well, if you look at this graph, you can see if you bought a share in TD this morning for $60, this afternoon it would be worth almost $62. So you could have sold it and made $2 profit on $60, not on $100. And it only took one afternoon, not one year.” Her eyes got bigger.

I flipped to the monthly stock price view.

“And if you bought the share last month for $55, you could have made $7 in one month.”
I flipped to the five year stock price view.

“But, uh oh, if you’d bought the share here” I pointed to 2008, “then sold it at this time here” I pointed to mid-2009, you would have LOST $30.

“That’s why you don’t want to put all of your money into stocks. Your Dad and I keep the money to pay for our house and food and the TV and the telephone in the bank. We only put the extra money, like for vacations, into stocks. Because it would be really sad if we couldn’t go on vacation and we’d be upset. But we would still have somewhere to live and something to eat and something to do. You should only risk the money you can afford to lose.”

And she got it. Whether she will make good choices when she’s old enough to control her own investments remains to be seen. But she did see that stocks are not safe investments and that only extra money should be put at risk.

Of Course I’ll be Safe: I Only Invest in Huge Blue Chip Dividend Paying Stocks

Can you say “Nortel?”

No company is immune from sudden, catastrophic failure.

Nortel, for those of you too young to remember was Canada’s bluest chip tech company with worldwide assets and employees. In mid-2000 shares were trading at $124.50 on the TSX. By 2002 it was worth less than $1 a share and was de-listed.

If you don’t believe it can happen again, search the history of Enron, WorldCom, Bre-X, Lehman Brothers, GMC, Chrysler and many more.

Dividend paying stocks do have a Secret Weapon that helps when the markets tumble. That helps make them lower risk than many non-dividend paying stocks. And dividend payers are usually older more established companies which may also make them safer investments. But you still need to have a truly safe base for your RRSP if you want to sleep easily.

What Kind of Investments Should Make Up the Safe Secure Fixed Income Part of Your RRSP

Cash
This is obviously a safe choice. Almost anywhere you invest your cash it will be covered by CDIC insurance up to a maximum of $100,000 per account. Make sure your cash will earn some interest, however. ING Direct, for example, offers a no-fee RRSP daily interest savings account.

Most discount brokerages do not offer ANY interest on cash balances at the time this was written. At some brokerages like CIBC Investor’s Edge you can get around this by buying no-fee mutual fund shares in a daily high interest account. (Please see ATL5000 High Interest Savings Account Fund at CIBC Investor’s Edge Online Discount Brokerage) At other brokerages like BMO InvestorLine you can’t unless you lock in $5,000 or more. (Please see Investing in AAT770. )

Guaranteed Investment Certificates (GICs)
Like cash, GICs offer a totally safe investment. They are insured by CDIC up to $100,000 if their term-to-maturity is 5 years or fewer.

GICs are often dismissed by financial advisors in recent years because the interest rate on a 1-year term is about 1.7-2% a year at the time this was written. Interest rates, however, have never been this low for this long. In 1991, I was earning over 10% interest on 1-year RRSP GICs offered by BMO. Not a bad return considering the investment was 100% insured and at no risk.

Boomer and Echo reviewed an insightful book by David Trahair in their article: Can You Succeed with an All GIC Portfolio? It’s worth reading. Did you know over the last 40 years, GICs have earned about 7% on average?

While I’m not advocating you invest only in GICs I am saying that having part of your safe secure base invested in GICs is worthwhile.

One caution when investing in GICs: Most GICs are not cashable. You cannot redeem them early. So if you suddenly need the cash they represent, you can be out of luck. You have to wait till they mature to get access to their cash value. If you might need access to your cash quickly, consider one of the other investment types.

You can buy RRSP GICs at almost any bank or credit union. The usual minimum purchase is between $500 and $1000.

You can buy GICs issued by a wide variety of financial institutions within self directed brokerage accounts. Usually the interest rates are higher than those offered directly at banks. The usual minimum purchase is $5000 per GIC.

Money Market Funds
Like GICs, the interest rates paid by money market funds have been hit hard over the past few years. Personally, I would not advocate investing in them right now when you could earn the same interest or more by investing in a daily interest account or GICs. Money market funds are not totally safe. They can lose money. And you have to pay a fee (a MER) which is deducted from the value of the fund before you are paid any earnings from the fund.

Term Deposits
Term deposits are very similar to GICs but are usually cashable after a certain period of time, often 30 days. Consequently, they usually pay a lower interest rate. They may require a larger initial investment.

T Bill Funds
These funds invest in government T bills only. They are very secure, however right now the rates paid by these funds are very low.

Bonds and Bond Funds and Bond ETFs
These are actually one of the riskiest investments for the safe and secure part of your RRSP. So in defiance of alphabetical order I’m placing them at the end of the list.

Buying individual bonds is difficult and can be costly. Most brokerages offer bonds for sale. The fee or commission is built into the price of the bond. That can make it difficult to compare different bonds. The face value of many bonds is also high which requires you to invest a lot in a single bond.

Bond funds make investing in bonds easier. You can let an experienced team pick and choose the best bonds. They have the buying power to negotiate the amount of commission they pay. And you can liquidate your holdings much more quickly and easily.

That said some of the best bond funds require a large initial investment. To buy PH&N funds through a discount brokerage you must buy a minimum of $5000 of a fund. There are annual fees charged by the bond mutual funds. Check these MERs carefully before making any purchases.

Bonds and bond funds may drop significantly in value if interest rates rise. People have been predicting this rise in interest rates and fall in bond values for several years now. One of these months it will actually start to happen.

[UPDATE: There are, of course, bond ETFs that like mutual funds invest in a variety of bonds. Unlike mutual funds, you buy and sell units of an ETF on the stock market like shares in a company. You usually have to pay a commission for each sale and for most purchases. Bond ETFs also have management expenses, MERs, but they may be lower than the annual fees for mutual funds. If you read about couch potato investing, you will find descriptions of commonly purchased bond ETFs.]

[UPDATE: in 2014 the US government has stated it will begin to stop “quantitative easing.” This may lead to a sharp increase in interest rates and a sharp fall in bond values. You should discuss the risks of investing in bonds with your financial advisor. Depending on your risk profile you may decide not to invest in bonds at this time. Personally I still have  money in bonds but I am expecting to suffer losses of up to 10-15% over the next few years.]

Concluding Recommendations for Building a Safe Secure Base for your RRSP Portfolio

In conclusion I would recommend

  • Invest at least $25,000 in truly safe and secure RRSP investments.
  • Invest in 1-2 year term GICs while rates are low and flat. Do not lock in to long terms at low rates.
  • If you invest in bonds, consider investing in a bond fund.
  • If you invest in a bond fund, to reduce the risk of losses, choose one with a short average term to maturity, such as the PH&N Short Term Bond and Mortgage Fund. (NOTE: The value and security offered by this fund may have changed by the time you read this article. Always fully research any investment suggestion before buying it. I’m not great at picking the winners!)
  • As your RRSP’s value increases, keep increasing the size of the safe and secure base. You want to end up with an investment pyramid built on a wide sturdy secure base, not an inverted pyramid balancing a top-heavy load of high-risk investments over a pinpoint of safe secure cash!

Further Reading

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Do you have your RRSP anchored with a firm safe base? What proportion of your RRSP is in safe fixed income investments? Please share your experiences with a comment.