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.

Related Reading

Join In
Have you discovered other pros and cons of mutual funds? Please share your experiences with a comment.2

The Types of Mutual Funds, Why They’re Good, and Quick Buying Tips

Posted on 2013 02 22 by BetCrooks

Most people think a mutual fund is just a tool to buy shares in the stock market in a lot of different companies. But mutual funds offer much more than just equity group buys. Mutual funds also invest in ways you may never have considered. For some types of investing, mutual funds are very useful indeed. But which funds are worth a very close look?

What Exactly is a Mutual Fund?

A mutual fund takes a pool of money and (usually) invests it in more than one business or financial holding or instrument. Investors can buy units in the mutual fund. Owning a unit gives the investor a fractional share of all of the investments that the mutual fund has purchased.

What Types of Mutual Funds are Offered for Sale?

Balanced Funds	Bond funds	Dividend Income Funds
Global Funds	Gold and Silver Mutual Funds	High Interest Savings Account funds
Income Funds	Index Funds	Money market funds
Preferred Shares Funds	Stock funds	T-Bill Funds
Wrap Funds

What Do These Mutual Funds Invest In and What Assets Do They Hold?

Bond Funds

In this type of fund, the fund manager invests in a selection of bonds. The bonds may be all government-issued bonds, corporate bonds, municipal bonds or a mixture. Bonds usually have a term at the end of which they mature or come due for payment. So bond funds can select bonds that are almost mature or that have terms of 1-50 years before they will reach maturity.

Bonds are bought and sold just like common shares. If you have a discount brokerage account, you can sign on and look for a bond for sale and buy it. The price, however, includes the commission charged by the seller. That makes it difficult to know if you are paying a good price for your bond. A bond fund can help you avoid this problem.

A bond fund buys many, many bonds and can negotiate for a lower commission on purchase. Bonds are often expensive, too, so by buying units in a bond fund you can buy a larger variety of bonds than if you were purchasing them individually. Bond funds will usually also have access to more bonds to purchase than an individual investor will. Your brokerage is unlikely to offer all of the bonds currently for sale. A bond fund, however, likely has access to almost all bonds currently on offer. (Can you tell I like bond funds better than buying individual bonds?)

PH&N is well known for its bond funds. The PH&N Total Return Bond Fund invests in corporate and government bonds from Canadian, American and other foreign issuers. The average term to maturity for the bonds held in the fund is 7-12 years. It can hold up to 25% of the fund in cash. It has clearly defined rules for how much risk it will take when selecting bonds. (Bonds are rated with A and B ratings by independent rating companies.) This is an actively managed fund. Right now, all bonds are at risk if interest rates begin to climb significantly and quickly. (I wish!) If you look at the Current Holdings for this fund, you will actually be able to see them trying to mitigate this risk through careful selection of terms and yields.

Money Market Funds

These funds are often considered a “parking lot” for money waiting on an investment decision. They don’t offer much income but they are not at high risk of losing money. (They do lose money sometimes though.)

Money market funds invest in short term holdings. These can include federal and provincial government debt securities, bank issued deposit notes and other commercial paper.

The CIBC Money Market Fund https://www.cibc.com/ca/mutual-funds/no-load-savings/money-market-fund.html has typically earned less than a 1% annual return for the last 5 years.

High Interest Savings Account Funds

These funds mimic a high interest savings account. For example, you usually buy the fund in $1 or $10 increments. If you buy $1000 of a $1 fund, you get 1000 units. Interest payments are made monthly on the daily balance of the fund.

These funds were created for two reasons:

1. People did not like losing money in a money market fund and wanted a perfectly safe, interest-paying place to park cash. HISAs are often CDIC insured just like bank accounts.

2. Financial institutions offering high interest savings accounts discovered this is another way to capture cash deposits.

There is another benefit for the issuer: If a person sells their entire holding before the monthly dividend, the issuer gets to keep the interest. This is the same as if you close a bank account before your interest is paid in. The difference is that many customers forfeit the interest on these funds because they want to re-invest elsewhere in a hurry. [UPDATE 2014: I’ve since discovered that in practice many institutions pay the interest earned to date if you sell all of your holdings mid-month. This is much better than I expected and I applaud them for it.]

Be aware that the “monthly” payment is not necessarily made on the last day or first day of the month. For example, DYN 500 has made payments to me on the 25 and when the 25 was a stat, on the 28 of the month. ATL5000 paid on the 4 th.

CIBC Investor’s Edge customers can buy units in ATL5000 the Renaissance high interest savings account fund. (For details, please see ATL5000 High Interest Savings Account Fund at CIBC Investor’s Edge Online Discount Brokerage.) BMO InvestorLine customers can buy units of AAT770. RBC Direct Investing customers can buy units of RBF2010.

T-Bill Funds

As the name suggests these funds usually invest in federal government issued Treasury Bills. Now, while interest rates are incredibly low, T-Bill funds are out of favour. However, in the past they have been an extremely safe place to park cash for a short term with a small return on investment. T-Bill funds can lose money.

The RBC Canadian T-Bill Fund http://fundinfo.rbcgam.com/mutual-funds/rbc-funds/fund-pages/rbf262.fs returned an annual average return of less than 1% for the past 5 years.

Preferred Shares Funds

Some companies offer two types of shares for sale: common shares and preferred shares. There are bond funds that invest only in preferred shares. The fund manager may pick preferred shares depending on the dividends, the term to maturity (if applicable), the price versus the call back price and other factors. They may select preferred shares only in certain industries, such as banks or insurance companies, or they may select preferred shares from a wide variety of business types.

The Manulife Preferred Income Fund http://pricesandperformance.manulifemutualfunds.ca/manulife/profiles/en/72129/fund/html/ is invested 95 96% in Canada and holds preferred shares in companies such as Talisman Energy, ~~Bell Aliant~~, ~~Enbridge~~ Cooperators, Power Financial and the Bank of Nova Scotia. It targets an annual return of 5% to investors. (Note: the return is not guaranteed, and the value of the units in the fund can rise or fall.)

Gold and Silver Mutual Funds

These funds can invest in either metal gold and silver or in companies that mine, produce and distribute gold and silver. It may be very difficult for you to own gold or silver metal. You may find a precious metals fund gives you the benefits you want without the risks and storage costs of personally owning metal.

The BMG Bullion Fund http://www.bmgbullion.com/reg_1/fid_1cad/tab_1/BMG_Fund_-_Class_A says it provides investors with a convenient way to hold gold, silver and platinum in bullion form. It purchases the actual metals and holds them. The bullion is then held in insured storage. As you might expect, the fee for holding this fund is fairly high due to the actual storage costs among other fees.

It’s important to know there are no dividends paid by funds investing directly in physical metals. If you are looking for dividends, you will need to look for a precious metals fund that invests in companies that mine, produce or trade in precious metals.

Stock Funds

The most widely known type of mutual fund holds shares in dozens, hundreds or thousands of companies. The holdings are managed by a fund manager. This manager decides when to buy more shares in a specific company, when to sell holdings in another company and how much money to keep in cash reserves in the fund. This type of manager is actively controlling the fund’s investments.

An example might be the Dynamic Power American Growth Fund http://funds.dynamic.ca/fundprofile.aspx?f=PW2K&lang=EN . [UPDATE: All of the following facts date from January 2013. The fund has changed again since then.] It is invested 89% in common shares of US stocks, 3% in foreign stocks, 4% in Canadian stocks and 4% in cash. The stocks it holds are 47% information technology stocks, 34% consumer discretionary stocks and 15% health care stocks. (The missing 4% is the cash.) Examples of its holdings include Google, Whole Foods Market, Regeneron Pharmaceuticals and Amazon.com. A single unit of this fund costs $8.41. A single share of Amazon.com costs $265.56. By buying units of this fund you can invest in many companies even if you don’t have hundreds of thousands of dollars.

Index Funds

Another type of fund buys the same assets in the same proportion as listed on a specific index. For instance the S&P/TSX 60 Composite (http://www.standardandpoors.com/indices/sp-tsx-60/en/us/?indexId=spcadntx–caduf–p-ca-l– ) is a list of 60 large capitalization companies traded on the Toronto Stock Exchange. An index fund that stated it was directly matching the TSX Composite 60 should hold shares in each of those 60 companies.

Be aware that in recent years a large number of new “indexes” have been created. Some of these are no different than if you sat down and wrote a list of company names. For example I could make the Crooks’ Household Index and say it included Metro, Canadian Tire and Shoppers Drug Mart. But, you exclaim, what about the dozens of other stocks that would fall into that type of category? Why aren’t they listed? Simply because I didn’t pick them!

If you buy an index fund, check which index it represents. Then go and research what is included in that index and why. Make sure the index makes sense.

The CIBC Canadian Index Fund https://www.cibc.com/ca/mutual-funds/no-load-growth/can-index-fund.html for example, says it “is managed to obtain a return that approximates the performance of the S&P/TSX Composite Index. If you read that closely, you will realize it is not a true index fund. A true index fund is not actively managed; it just holds the same stocks as the index it represents.

Balanced Funds

These funds invest in a blend of financial choices. They may have money invested in short term commercial paper (money markets), bonds, preferred shares, common shares, gold, precious metals and other options.

The purpose of a balanced fund is usually to provide the customer with a single purchase that provides exposure to a variety of investments. Often the balanced fund seeks to ensure a steady profitable return by actively managing where the money is invested. Bonds, for example, help protect a fund from a drop in the value of common shares.

Shares, in turn, help protect a fund from a drop in bond values if interest rates rise. These balanced funds are often suitable for long-term investing in RRSPs and TFSAs.

The Fidelity Canadian Balanced Fund http://www.fidelity.ca/cs/Satellite/en/public/products/mutual_funds/asset_allocation/cdn_asset_allocation/bl is an example. It holds shares in 71 81 equities and 967 ~~927~~ bonds. About 41 43 % of the fund is in Canadian equities, 34 37 % in Canadian bonds, 11 7 % in Foreign equities, 11 10 % in Foreign bonds and 3% in cash.

Wrap Funds

Be a bit cautious about the differences between a balanced fund and a wrap fund. A typical wrap fund is a fund that buys units in other mutual funds. So while a balanced fund might buy 3 issues of bonds, and 7 common stocks, a wrap fund might buy units in a bond fund and units in an equity fund.

The problem is that a wrap fund may charge another MER (fee) on top of the fees already charged by the funds it is buying into. In the above example, the wrap fund might have a MER of 1% and the bond fund it owns might have a MER of 1.25% and the equity fund it owns might have a MER of 3.5%. That’s a lot of fees.

The balanced fund will typically have only one fee as it is investing directly in the bonds and stocks it holds.

If you are not sure if the product you are being offered is a wrap fund, ask! Ask for a clear written explanation of the fees and MERs before you agree to purchase anything.

In general, wrap funds are less profitable for the investor (you) than for the seller (the bank or finance company.) Be wary.

That said, some balanced funds are also actually investing in funds not directly in assets. They may or may not have high fees and MERs. You have to check the details carefully.

Income Funds

Income funds can be any of these other types of funds. There is no “one” type of investment in an income fund. You could have a fund that holds 100% common shares; 100% preferred shares; or 100% bonds and it could be named an income fund.

Don’t try to compare income funds without closely examining what’s held inside them. You can’t compare the past annual return of an “income” fund that holds 75% stocks with an “income” fund that holds 95% bonds. The returns will be significantly different because the asset classes and the risks are significantly different.

Global Funds

Similarly, Global Funds can hold equities, bonds or even just foreign cash. The name is meaningless. You will have to look at the holdings to decide what type of fund it really is. Even the name “global” can sometimes be misleading. Some “global” funds hold 25-50% Canadian equities!

Dividend Income Funds

Again, these are funds that could hold a variety of assets. The name implies they are invested in equities that pay good dividends. Check though! Some funds have misleading names.

Why Buy Mutual Funds? Quick Tips to Consider and 4 Types Worth Buying

Mutual funds can help with specialized investing goals. It’s worth considering buying the following types of funds:

Bond funds

(Also consider Bond ETFs)
Bond funds have access to more bonds than individual investors. Bond funds pay lower purchase commissions, too. Buying a bond fund gives you greater bond diversity than buying a single issue or two. An actively managed bond fund can also reduce risk due to rising interest rates. Look closely at the PH&N bond funds.

HISA funds

Most brokerage accounts are not paying any interest on cash holdings. If you can, you may want to park your cash in a high interest savings account fund while you wait to re-invest. InvestorLine, unfortunately, requires a minimum holding of ~~$25,000~~. [UPDATE: As of April 11, 2013 the minimum for the BMO HISA AAT770 is $5,000.] Investor’s Edge has a minimum of only $1,000. Check out DYN500 and ATL5000 among other funds. Look for early redemption fees and minimum holdings as these can change periodically.

Precious Metals funds

(Also consider Precious Metals ETFs)
Gold bugs may want to invest in a fund that stores physical bullion safely. The BMG Bullion fund might be worth a look.

Preferred Shares funds

(Also consider Preferred Shares ETFs)
Investors looking for reliable income without much if any chance of a capital gain but with a pretty high degree of safety for an equity investment may wish to hold a preferred share fund. Look for income funds that invest in preferred shares such as the Manulife Preferred Income Fund.

Major Index funds

For investors who cannot, for one reason or another, buy ETFs an index fund with a low MER (fee) that mirrors a major stock index such as the S&P/TSX Composite or the American S&P 500 might be worth considering. Check whether the fund actually buys the index. A true index fund is not actively managed and moves up and down daily with the market it mirrors.

Whole websites have been written on the benefits of Couch Potato investing. You may want to read through one.

Disclaimer

I’m not a financial advisor and have no training in providing investment advice. In fact, I’ve been known to make some spectacularly bad investing decisions. Please use your own native wit and seek professional advice where appropriate.

Related Reading

Join In
Are there other types of mutual funds I’ve missed? If you have invested in a different type of mutual fund to serve some investing goal, please share your experiences with a comment.