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Questions to Ask When Picking A Mutual Fund

Everybody should be investing their money and for 99% of millennials this means buying ETFs that represent a broad market index. Blackstone and Vanguard are an easy way to go – with returns far in excess of a savings account. Whatever is left in your after-tax, after-mortgage income, dump it into Vanguard S&P 500 on your $9-a-trade Investorline account and forget about it.

However, for those who are interested in getting a better return than the market (as well as less volatility) to build more wealth and a larger retirement savings account, mutual funds will be the way to go.

What’s the catch? The vast majority of mutual funds are garbage and underperform the market net of fees, which means that you are better off investing in an ETF. Of the mutual funds that outperform, you will rarely find them sold to you unless you know where to look.

So when a financial advisor, financial services representative, or investment advisor gives you a list of mutual funds to look at (ask for a full list of what they have to offer, otherwise they will default to peddling their own bank or financial institution managed funds whereby they will collect the most sales revenue – and financial services representatives are usually only qualified to sell their own bank’s products), what are things to look for?

How Has The Mutual Fund Performed Relative to the Benchmark

“This mutual fund is really good, it returned 12% last year – all of my clients are very happy with it.”

Sure, but the S&P/TSX earned 15% last year. So what incentive do you have to purchase this mutual fund as opposed to just buying an index ETF, getting a better return and not paying any fees. Being the same or beating it slightly also does not justify the hassle of getting the mutual fund. And beating it for one year is also not very good intel – look for a track record of consistently beating the benchmark over a long time horizon (5-10 years) before you consider a mutual fund to be any good. Also consider how the fund has performed in downturns – if they are just taking on more risk and betting on moonshot stocks, you might be hurt a lot harder on the way down. A rising tide lifts all ships.

An all Canadian stock mutual fund holding pretty much the same weights for Royal Bank, Canadian Tire and Loblaw Companies as the S&P/TSX is known as an “index-hugger”. Basically, the mutual fund is just taking a 2% management tax for buying the same thing as the index.

Is the Benchmark Appropriate for the Mutual Fund

Be very careful when you look at the benchmark for the fund in question. If it is a Canadian mutual fund that broadly invests in equities, the benchmark should be the S&P / TSX Composite. If it is a dividend fund, there are dividend benchmarks and dividend aristocrat benchmarks.

If you do not have an appropriate benchmark, you cannot evaluate performance.

This is tricky sometimes – I was asked by a friend to look at an RBC Technology mutual fund – excellent returns, as would anything with Nvidea and Amazon in there somewhere would be doing. However, the benchmark was a 90 day Governement of Canada note. Basically, they were comparing the performance of a technology focused mutual fund against a savings account more or less. If the advisor does not provide you with a relevant index, find one yourself – in this case, possibly a Blackrock technology index.

Are Dividends Reinvested?

This is one of the most annoying tricks you have to watch out for. The mutual fund with dividends reinvested is compared against the S&P 500 index. However, the S&P pays dividends too, so you are cutting out 2% of performance in an unfair comparison.

Make sure to ask about this.

Performance is Gross of Fees versus Net of Fees

Gross of fees is dishonest. Always ask for returns that are net of fees, because this is what ends up in your pocket. No one cares if you make $3 million dollars in revenue a year and realize $30 in profit. The number that matters is the $30. Gross of fees is a meaningless figure and when you see this you have to ask why they chose to write gross instead of net – what are they hiding? Are fees egregious?

Whenever you see any sort of return metric make sure it explicitly says net of fees. If you find out an investment advisor is selling you something gross of fees, consider another advisor because the client relationship is built on trust.

This usually comes up when the investment advisor tries to market a bespoke solution for you. It plays to your psyche because it makes you feel special. You are special because you are allowed to participate in this investment vehicle. Normal people are not allowed to – private pools, separate managers.

As with anything with financial products, the more opaque the product, the more leeway the structurer has to embed fees. The more lucrative the fee, the greater the kickback to the salesperson.

Avoid Balanced Funds

The asset management industry has successfully marketed a balanced fund product which is based on “conventional wisdom” of 60% equities and 40% bonds. As such, a balanced fund which has this mix already is an excellent product for you.

I can disclose that my portfolio is 100% equity (I’m rich, trust a rich person) and you should be too unless interest rates are high enough to justify investing in bonds or you need the money soon (retirement, kids going to college) and cannot handle volatility.

Also, as with the above, this is a fee grab. Fixed income funds have lower management expense ratios than equity funds, but the balanced fund has an MER that is similar to an equity/stock mutual fund. If you are determined to have 60% stocks and 40% bonds, just get a stock mutual fund and a bond mutual fund separately with the same weights.

Do not forget to avoid segregated funds too. Anything packaged means layered fees.

Dig Deep in Underlying Portfolio Weights

Just because you do not make final investment decisions does not mean that you should not scan through the underlying holdings.

I was asked to look at a portfolio for a senior citizen, who presumably does not have a long investment horizon, and the portfolio included Valeant when it was worth more than RBC. As we know now, that was not sustainable and VRX stock has gone straight to hell. This could be one of those funds that did well when the market was doing well and had no margin of safety built in. If you are not comfortable with the underlying holdings, do not buy it.

Beware of Misleading Investment Return Charts

Scrutinize every chart they produce for you closely to see if it is meant to convey a particular message (which is buy this fund).

Last time I saw a fund recommended for someone versus their current Fidelity heavy portfolio over 10 years since the financial crisis. The potential IA said, “you ended up with the same performance despite taking on a lot less risk”. The end of the chart both ended around $1.5 million dollars – except the Fidelity portfolio started from $200,000 while the portfolio they recommended started from $400,000. Incredible dishonesty.

Sometimes No Mutual Fund is Good Enough and You Do Not Have to Buy

A colleague of mine wanted very specific Chinese market exposure after reading about our thesis on this blog. However, he did not want large cap exposure and instead felt that the broader Chinese market would be the way to go (where the appropriate benchmark is the MSCI China Index).

When he asked his IA about stocks that fit this profile, every single fund missed the mark for at least one of the categories above. None of them beat their benchmarks over time and they came with egregious management fees. He was better off buying the index. If he felt it was an alpha story instead of a beta story, he was better off not buying.

Why does this happen?

The mutual fund industry exists to make a profit. There are plenty of good funds and good fund managers that are available in the U.S. and other countries that will not be available in your country because there is not enough demand to benefit from economies of scale. A fund has to have enough assets under management to charge a management fee on to justify legal, compliance and salesperson costs. So for this instance, there was nothing good available.

In these cases you just have to be disciplined enough to say no, I am either just buying the index or not taking this exposure altogether.

InvestingAre Stocks Cheap After COVID-19 – Part II · Real Estate Investment Considerations and Strategies · Why Investment Bankers Are Bad Investors · The Sky Is Falling · Beginning Investor Q&A · Choosing the Right Investment Advisor · Understanding China and the Investment Thesis · Emerging Markets We Are Investing In Right Now (for Canadians) · Investing in Stocks Today with the Trump Backdrop · Buying Property as an Investment for Young Professionals · Observations on Chinese Assets and Investing · Should You Enroll in the Company Employee Share/Stock Purchase Plan (ESPP)? · Dividend Reinvestment Plans (DRIP) · Investing Mistakes for Family and Friends · A Conversation About Risk and Reward ·
ex investment banking associate

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