MUTUAL FUNDS: GETTING IN THE WEEDS ON INVESTOR ISSUES

WHY MUTUAL FUNDS ARE ABUSED AND MISUSED

A lot is being written about Mutual Funds being the investment of choice by Canadians. The fund industry has done a great job of sales and marketing, and since the bankers joined the fund party there are really very few competing products to turn to. In fact many Canadians would have no idea what alternatives they should consider if they did chose not to invest in Mutual Funds. So that begs the question; why are so many bloggers and DIY investors so upset about funds and how they are sold? Can funds be all bad if almost every Canadian adult seems to own at least one fund?

Let’s start by acknowledging that few things in life are all bad. Mutual funds began life as a low cost, highly diversified product that allowed average investors to participate in the equity and bond markets. In the 70’s and mid 80’s you could well have made an argument that freeing investors from falling GIC rates allowed investors to break free from the bank GIC’s and share in the rising stock markets. So let’s concede that mutual Funds began their life as a very good concept to bring investment options to the masses. Having conceded that point, what is so different today?

Lets review some of the old strengths of funds and why they might no longer be strengths in todays world!

Old : When funds first gained popularity investors generally could not invest in equity markets unless they utilized a brokerage house that charged what we now call “full service” brokerage fees. In short you might pay $300.00/trade and constructing a diversified portfolio could cost $8,000-10-000 in broker fees. That generally meant most investors were shut out of the equity markets unless you were wealthy.

New : Today investors can utilize a discount broker (DB) to access the equity markets at fees ranging from $10-29/trade. The DB web sites offer research that is less likely to have a bias and that allows investors to utilize security screens and other investment tools to assist them in choosing securities.

Old: Fund fees in the booming 80’s were often in the range of 3% MER on funds that were earning 12-15% in annual returns. Investors looked at the net return (often over 10%) and felt the returns in excess of GIC rates warranted the fund fees... and they were probably right.

New: New products such as ETF index funds have been created. The new ETF index funds offer low cost diversified portfolios at MERs that are often less than a tenth the cost of current mutual funds. Now you can build a whole diversified portfolio for less than a half of one percent in fees. On top of that, the past decade has seen extremely low returns on equity markets. With MERs refusing to decline as economy of scales grow, investors are now finding themselves paying over 2% in MERs for funds that have lost them money for years. While a 3% MER once allowed for a 10% net return on funds, investors are now paying 2.5% to earn less than they would make by buying a GIC.

Old: When funds first arrived on the scene they were often small and nimble. A high quality manager could make a difference and truly add value through smart trading decisions. As well, a well connected manager could gain advantage by having better knowledge of a specific firm or market sector. Indeed, if you check some of the largest and most successful long lasting funds you will see many examples of funds having a great first few years in the market.

New: We now have over 2,000 mutual funds in Canada holding over $600 billion in assets. Fund managers also manage pension plans in many cases. Every one of the 2,000 funds has a team of highly trained analysts and portfolio managers with MBA’s and CFA’s. It is now virtually impossible for a fund manager to outperform the markets because everybody has similar skills. As well, the fund industry is so large that they “are” the market! Trading between fund managers nets out over the year but the fees continue to increase with every trade. New laws on disclosure of financial data mean that the well connected broker/trader can no longer get information before the market. Despite what you see on TV, every fund manager knows where Russia is located and that they buy winter tires!

THE FEE FACTOR: I was reading a popular finance blog by a Canadian journalist and I am sure one of the comments must have come from a fund salesperson (unattributed of course). He expressed the view “fees do not matter, its the net return on investment that counts”. Only a fund salesperson could believe the two issues are not connected to one another. I agree wholeheartedly that fees are irrelevant if a fund can consistently earn better than the benchmark return after fees! The problem of course is that fund returns very rarely manage that feat. In fact the frequency of mutual funds beating the benchmark seems to be about what you would randomly expect with 2,000 managers trading securities with each other. Typically, less than 1 in 5 can match the standard benchmark indexes for any length of time. For those looking for empirical evidence, you can review the Standard & Poor’s SPIVA scorecards.

I would suggest the question is not “can a mutual fund with a 2.4% MER beat the index”, but rather can anybody tell me which one will manage the feat in any given year? If not, why would I not just buy the index for one fifth the cost?

SOLD NOT BOUGHT: THE ADVISOR FACTOR: The evidence clearly shows that Canadians have a greater willingness to pay fund fees (MER) than international investors. With MERs averaging near 2.4%, and with Canadians having $600 Billion in funds, the industry stands to pull in billions of dollars a year in fees. In the U.S. market fund fees are considerably lower than in Canada (even allowing for different rules on what is contained in the MER) and American investors are making ETFs the fastest growing securities product in the marketplace. So why are Canadians different?
Funds are sold not bought! Investors place their trust in salespeople who are licensed as a “salesperson” but who prefer to give themselves the title of “ADVISOR” on their business cards.

There is no licensing available in Canada for a mutual fund “ADVISOR” or “FINANCIAL PLANNER”, but there are licenses for mutual fund sales person and registered dealing representatives. Canadians place their faith in their banks and their advisors and choose to believe they will be rewarded by unbiased advice from those they trust their hard earned money to. What Canadian investors seem to be unaware of is that the trusted advice is coming from people trapped in a commission system. It truly is a case of “don’t hate the players, hate the game”.

WHY YOUR SALESPERSON HAS NO CHOICE: A salesperson is either self employed (rarely) or works for a larger firm. The large firm will both manufacture and sell funds (think Investors Group) or will just sell funds. Fund sales people tend to wrap themselves in the “financial planner” title, although they rarely provide comprehensive planning. Planning is a labour intensive task for which salespeople do not receive a fee or commission. It is similar to the free toaster when you open a bank account. Salespeople receive fees ONLY when they convince you to invest your money into a fund. At that point the industry forces the behaviour of the salesperson to mirror the fund’s objective. The funds objective is to maximize commissions. Only behaviour that maximizes commissions will generate payments to the salesperson.

SKIMMING YOUR MONEY: Mutual Funds take their revenue from YOUR account. Most investors understand the fact that fund companies and salespeople get paid, but few realize how or more importantly how much they get paid.

The primary reason investors are unaware is that the industry intentionally hides the fees and commissions from the investor. Imagine if fund companies ran a credit card business the same way they manage your funds. You would never get a statement of interest charges, would rarely be aware what the current interest rates are, would never know how much they took from your bank as a payment and your sign up documents would be written as a 50 page legal contract. Your statement would show a balance but no way for you to confirm how they arrived at the balance. In short, you would not allowthis type of reporting to happen with a $500.00 credit card. So why is it acceptable for your life savings?

MANY WAYS TO SKIN A CAT: The fees are hidden as discussed above; however a further issue is that the commission splitting between the fund and the salesperson is also hidden. Salespeople often argue that "how" or "how much" they get paid is not relevant to investors. Nothing should be or could be further from the truth

Hidden Gems: One reason why it matters is that different fund companies can pay your salesperson different commissions to sell Fund A instead of Fund B. Now consider the last recommendation from your salesperson to buy ABC Canadian Equity. Did you know that XYZ had a lower cost to you and a similar performance history but paid lower salesperson commissions? Did your salesperson recommend ABC because their firm wants more high commissioned funds sold and they pressured your salesperson? Was it because your salesperson was having a rough spell financially and needed the commission? The key point is I do not know, and neither do you.

A second hidden gem is the fact the very same fund can be sold to you in a variety of ways, all with different costs to the investor. So if you believe ABC fund was the best choice, was that based upon a seven year lock-in requirement known as “deferred sales charge” that pays a hefty up-front fee to salespeople; or was it based upon a “front end load” that paid a smaller up-front fee to the salesperson? Did you know your salesperson could sell the fund with a 0% front end load and still receive the annual trailer fees from the fund company as compensation? Did you know the salesperson could sell you an “F Class” or advisor class fund with very low expenses and no commissions? In this case the salesperson negotiates a fee with the investor for their services in an open agreement that sheds light on your costs.

The third broken leg of the commission process is hidden trailer fees. Trailer fees are a hidden commission paid to your salesperson every year by the fund company. The fee is only paid if you stay with the fund company. Now ask yourself why your salesperson insisted you “stay the course” in the recent market meltdown? Was it because going to cash would end their trailer fee revenue and cost them income? Did you know that the salesperson benefited by keeping you exposed to a falling market? To compound things further, the annual trailer fee varies by how you were sold the fund. This means your salesperson has a very direct conflict of interest. The higher your fees the more commission your salesperson likly makes from behind your back trailer fees. Do you still feel confident your salesperson is a trusted “advisor”?

As I stated earlier, the salespeople are caught in the system. The fund companies outline the commission rules and the salespeople have a difficult time avoiding the conflicts inherent in the system. A few truly good ones manage to balance investor needs with their own income requirements, but most slowly give in to the system and begin to feel they are “entitled” to the fees. When asked about the practice of accepting hidden commissions the most common refrain is a combination of “investors do not care” or “I work hard for my money”. The first is hard to assess since the investor is unaware of what is happening for the most part. The second is an irrelevant comment, since we all work hard for our money but few of us feel we need hidden commissions to make our business model work.

MONEY MAKES THE WORLD GO AROUND!
If we put aside the issues of excessive cost, manipulative sales practices and poor performance; is there an argument for mutual funds as an investment vehicle?

The answer is “yes”. The cost or MERs make mutual funds expensive as a core holding in a portfolio versus a low cost index fund, however mutual funds offer diversification and professional management. If an investor wants to hold some small cap or emerging market assets, a good fund manager can likely add value. The cost is high but so are the risks in investing in small cap or emerging markets without knowledge of the markets. As an example, I hold an Asian focused mutual fund as a very small weighting in my portfolio. I could not do the research required to build a high quality diversified Asian portfolio and I did not want to own the whole Asian market via an ETF index fund. I felt the professional management was worth the cost, not to make greater gains but to reduce the risk of large losses in a higher risk market.

CONCLUSION: Mutual Funds are a niche product being used to build core portfolios by salespeople who generally know better. The rationale for this volume of fund sales, from my perspective, can only be based upon the desire by the industry for the billions of dollars in hidden revenue streams.

In the light of full disclosure of fees, commissions, performance numbers and knowledge of available options, I believe investors would make different choices. Where more of disclosure is provided (the U.S. for example) investors have selected ETFs for their core holdings in many cases. In Canada we may never know what an informed investor might do because our current system does not generate sufficient numbers of informed investors to determine how we might choose to invest.

What Can You Do: In a world of busy people trying to make a living, raise families, and manage day to day cash flows there is precious little time to ride shot gun on your salesperson.

The average person has two viable options:

a) manage your own investments with a low cost “couch potato” ETF based portfolio or

b) separate who gives you advice from who sells you your investments.

The second option can be attained by hiring a financial planner or investment consultant who gives advice but does not sell securities, and then take that advice to a salesperson for the execution of your security purchases and sales. In both situations mentioned the conflict of interest between advice and security sales has been reduced or eliminated. That is a vital first step in taking control of your investments.

Sois mike