The Mutual Fund Conversation
Living in a city with a high cost of living makes it difficult to save money. Eventually, most young professionals start earning more as they move up in their career progression or become more responsible for spending/stop living paycheque by paycheque and start investing to grow their capital to buy a condo.
Banks are fairly sophisticated and have access to a lot of personal data, so when this happens the bank teller will be triggered by a pop-up on their screen to set up an appointment with a financial advisor so that you can buy a mutual fund.
The financial advisor or financial services representative will mention that the prospective investor is young and should therefore have a basket of all equities (stocks) so that they can aggressively grow their capital while they are young and can accordingly take calculated risks (have human capital).
A general overview is provided in our investing section.
So the question now is, should you buy a mutual fund?
If the alternative to purchasing the mutual fund in question is continuing to hold cash, the answer is a resounding yes, for reasons that we outline in other literature.
The next question is, should you buy THIS mutual fund that they are prescribing to you?
That question takes more analysis. Mutual funds that have major blue-chip (big, safe companies with good track records) stocks are good in an absolute sense but are bad in a relative sense. For instance, why settle for 6% a year when you could get 8%? Compounded over a longer time period, this could make a substantial difference in your earnings.
What Is A Good Mutual Fund?
A good mutual fund follows its mandate, outperforms its benchmark consistently over time and tends to lose less money during market downturns (capital preservation). Obviously, finding a good mutual fund is hard to do, especially if you are an unsophisticated investor.
What Is A Benchmark?
A benchmark is the standard that the mutual fund is compared against as a performance measure. For a mutual fund that only invests in large Canadian stocks, it should be compared to the S&P/TSX. For a mutual fund that includes all North American stocks, the benchmark could be a blend of the S&P 500 (US) and the S&P/TSX, weighted by the constituents of the mutual fund portfolio.
Obviously, outperforming the benchmark is ideal for picking a mutual fund. If the mutual fund is not beating the market net of fees, there is no reason to invest in the mutual fund unless there is some other factor desirable to the investor.
This is not to say that the fund has to beat the benchmark every year – fluctuations can be caused by broad stock market movements in the short term, so if the one-year performance for the benchmark is better than the mutual fund but there is a sound portfolio manager with good investing discipline with a track record that beats the benchmark consistently over a long period of time, this may still be a good fund.
Is the Mutual Fund’s Benchmark Appropriate?
Evaluating whether the benchmark itself is appropriate for the mutual fund is not simple. For example, if we look at a mutual fund with small cap stocks (junior companies) that publishes its benchmark as the S&P 500, we may see that it beats the S&P by a large margin over the last little while. However, the S&P is heavily weighted towards big stocks (Coca Cola and Apple type companies) which are far less risky. As such, the appropriate benchmark may be a small cap index instead.
If a mutual fund focuses on technology and has most of its holdings in Alibaba and Google, an appropriate performance yardstick may be a global technology index.
Also, be careful of when mutual funds move away from their published mandate – for instance a mutual fund that touts itself as a defensive, value driven fund that starts putting money in Amazon. By no means is Amazon necessarily a bad company, but it makes performance attribution difficult and may not serve the needs of the investor. This is known as style drift.
Considering Management Expense Ratios in Mutual Funds
Even if the mutual fund beats its benchmark, it still has to pay management fees. Management fees are reflected in the Management Expense Ratio (MER) that you will find on any marketing document for the mutual fund. Management expenses are fairly light in the US as the market is very competitive, but can be very heavy in markets such as Canada.
The MER is the percentage of the total assets invested that are taken by the mutual fund as revenue to pay the portfolio manager (the person who picks the stocks), the salesperson (the person who is selling you the mutual fund) and overhead (the office that is rented to sell to you in and the administrative staff for the fund). The most important metric to look at is if the mutual fund beats the benchmark net of fees on a consistent basis.
Past Performance Is Not Indicative of Future Results
After digesting the above, it is important to remember that forecasting the future is impossible. A manager who performed well over the last five years could have had great vision or gotten lucky or both. The world is dynamic and business adapts to a changing world – strategies that worked previously may lose usefulness going forward.
Performance evaluation is important in the way that it helps us isolate why the fund performed the way that it did – assuming the manager did well, was it because the market was broadly up?
If he beat the market was it because he was more heavily weighted in certain sectors or smaller cap stocks?
If he chose the right sector, how did the stocks he chose in the sector perform versus the rest of the sector.
Permutations are endless, but can give us confidence in a mutual fund if outperformance is paired with a record of investing discipline and a clearly defined mandate.
This Is Complicated, What Do I Buy? Index Funds
If you are willing to put in the research, there are mutual funds that follow the mantra of preserving capital and employing disciplined value investing that will grow your money beyond the stock market.
The problem is, that takes time to understand and the incremental return may not be worth your effort – especially if you do not know if you have picked the right one. If you are not confident you can beat the market, you should consider buying the market.
As such, an alternative is to purchase index funds via ETFs (exchange traded funds – these can be bought and sold like stocks on a personal self-directed investing account). Funds provided by Vanguard or Blackrock hold a basket that replicates major stock indices such as the S&P 500 or S&P/TSX (Canada) or a China index. With these instruments, the only risk you take on is the risk of the market – something that cannot be avoided.
These days, there is a large amount of customization for exchange traded funds so investors can get dividend stocks, defensive stocks, ethical stocks, sector specific exposure or practically anything else. Keep in mind, the more niche the fund, the higher the fee and the lower the liquidity (the harder it is to sell it or buy it).
Performance evaluation is an exhaustive science and this article only scratches the surface of finding truth and justice in mutual funds. However, it is a good start for anyone looking to start investing.