How to Evaluate Mutual Funds and Choose which Funds to Buy

Posted on 2013 02 25 by BetCrooks

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.

Related Reading

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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.

The Benefits and Drawbacks of Mutual Funds

Posted on 2013 02 23 by BetCrooks

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:

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.)
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.