Investing Intelligently recently wrote a nice rebuttal of Rob Carrick’s article on how actively managed funds handily beat the index during the last bear market. You may not be able to count on mutual funds outperforming the index in the next bear market though. David Breman notes in today’s Financial Post that Canadian equity funds fell 6.1% in the month of November barely beating the TSX Composite Index, which slid 6.2%:
Fans of actively managed funds will often defend the hefty management fees associated with mutual funds by saying that active management shines when markets turn volatile. That is when money-management expertise can steer dollars away from obviously overvalued, over-hyped sectors and into areas that should perform well.
The November results, however, show that this is easier said than done.
Also, Jon Chevreau confesses in a recent blog post on how he gave up on mutual funds after publishing a “Smart Funds Guide” for many years:
I stopped writing the guides after the 2000 edition because I kept asking my fund analyst coauthor how it was that the one hundred “Smart Funds” we chose often were beaten by the index by which they were measured. Each “Smart Fund” included graphics of the performance of the fund versus the index. After awhile, I started to wonder if some of the best funds didn’t beat the index, what did this say about the “Dumb Funds?”
So, why do investors continue to flock to mutual funds? Is it as John Bogle likes to say a triumph of hope over experience or is the general public unaware of the corrosive effect that high fees have on performance?
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14 responses so far ↓
1 Potato // Dec 6, 2007 at 3:54 am
It’s a good question. I think a number of factors are at play, mostly coming down to different shades of ignorance.
First off, I don’t know how many people know there are alternatives available that perform better. Most mutual funds promise better returns than GICs (or at least the advisors/sales people at the bank promise better returns than GICs), which may be the only other long-term investment a naive investor may be aware of. Or, at least, comfortable investing in (since the stock market can be scary, especially if you don’t have much to spread around). Then, picking between mutual funds can be quite difficult, and if asked, the person at the bank will usually steer a customer to one of the managed funds…
Personally, I’ve always been leery of the costs of mutual funds, and have been invested in stocks even though it was probably too risky for me with not much money to spread around. Even though I thought I was relatively savvy as an investor, I only found out about low-MER index funds via your blog! (Thanks for that)
2 Plan Your Escape // Dec 6, 2007 at 9:23 am
Most people a) don’t know to even look at the MER on a fund and b) don’t appreciate how large and effect an extra 2% in fees has in the long run. That’s been my experience anyway.
Once I figured out a) and b) and combine that with returns that aren’t any better than indexes I forgot about managed fund all together!
3 Phil S // Dec 6, 2007 at 9:24 am
Back when I was just getting my career started, I relied upon a basket of mutual funds for my RSP. At the time I was too busy learning the ropes for my career in engineering so I didn’t have any time to put into learning about investing. As a result, I relied upon an investment advisor associated with my employer’s Group RSP plan to pick some funds for me.
Later on, I discovered that the investment advisor didn’t choose the funds that were best for me, they were choosing the funds that were the best for them. In other words, they were pushing product - picking funds for me which would give them the highest commissions. Later on in life when I was ready to make my first non-RSP individual stock pick, I discovered how this slimy world of investing worked and so my first ever stock pick was a mutual fund administration company - BPI Financial, who operated BPI Mutual Funds. It made sense to me that no matter how the stock market performed, the mutual fund management company still earned their pound of flesh as they skimmed our money off the top as their earnings. Over the ensuing years, BPI was bought out by CI Mutual Funds, and later converting to the CI Financial Income Trust. That original investment netted a total 600% return for me over a 6 yr span (excluding dividends and distributions), while the mutual funds I had maybe doubled in value on average. I ended up selling off CIX last year for a variety of tax reasons and to help pay off some debts. But that whole experience taught me a good lesson…
Since then, I have owned Dundee Wealth Management which earned me a 20% 1-yr return while their mutual funds only broke even for me over the same period. The only reason why I sold off Dundee Wealth was a few years back when I wanted to make the initial downpayment on my condo, I sold it to raise cash - if I had held on, then the recent bids to take them over would have pushed my returns through the roof!
Several months ago, BNN (when they were still called ROBTV) had a segment where some analyst pointed out that in almost all cases, the stock of mutual fund management companies have outperformed the mutual funds that the same company operates. At the time, the mother of all mutual fund companies in Canada was the Investors Group division of Power Corp and among the publicly listed pure-plays in the mutual fund industry, I think CI Financial was #2. I don’t know who outranks whom right now, but it looks like Dundee Wealth Management will be taken over soon.
Of course all of the Big 5 Banks also operate mutual funds, but their revenues from that business are usually miniscule compared to their overall businesses, so it’s not a “pure-play” in the mutual fund sector. Similarly, all of the big insurance companies also either operate their own mutual funds or are heavily invested in another mutual fund company (for example Sun Life and Clarica Life together own the controlling share of CI Financial, something like 80% of shares the last time I checked, which is admittedly a few years ago).
But there should be no doubt in your minds that the wealth management business of mutual funds is always a cash cow that provides these companies with a nice steady flow of income. It should be something for you all to consider the next time that you’re picking stocks… None of them will shoot up 5000% like a junior mining or junior energy stock, but from my experience, all of the big guys in that sector have slow and steady growth.
4 Canadian Capitalist // Dec 6, 2007 at 9:39 am
Wealth management is a nice business because there are two avenues of growth: (1) net sales that add to assets under management every year and (2) market growth of assets.
I’ve owned AGF at one point, but currently don’t hold any pure play mutual fund stocks.
5 FourPillars // Dec 6, 2007 at 10:07 am
I think the big bear market of 2000 was a bit unusual in that it was only certain parts of the market that got hit hard ie tech, so value oriented funds managed to do quite well. The indexes took quite a hit because of tech - especially here in Canada with Nortel…anybody remember them?
I believe the main Cdn index is now capped so that no stock can be more than 10% of the index which should help avoid this situation in the future.
Mike
6 MikeH // Dec 6, 2007 at 2:41 pm
Even for the more knowledgeable investor, I think psychology has a lot to do with choosing “active” mutual funds over indexed ones.
The rational part of my mind says:
“Keep fees low - index everything. You can’t do any better than the market as a whole.”
My ego says:
“Who just wants to do as well as everyone else (index)? That extra 2% off the top doesn’t matter if I can make 20%.”
That being said, my ego has lost me more money over the years than it’s made me.
BTW: I hold both index and active MFs. Reason and Ego fight constantly
.
7 tyler rooney // Dec 6, 2007 at 3:50 pm
I think it’s also worth noting that just saying “mutual fund” doesn’t necessarily mean high management fees. You can go and open an account with Vanguard and get razor thin MER on their mutual funds.
I think the difference between the average person and people like us (those who read personal finance blogs) is quite large. I’m still surprised to hear how many people don’t use online banking and bill pay features. And if you’re in that category, you probably want a physical person to talk to about investing which usually mean going to your current bank. And most places with physical locations (like Fidelity or banks) aren’t going to hammer home the importance of keep fees low. Hell, I dare you to go on fidelty’s website and try to figure out what a new investor would do and if you’d have any confidence in your decision.
Buying ETFs is even more complicated for the average person. At least with mutual funds you can invest any amount of money (not a multiple of a stock price) and it’s easy to get a no-load fund. I think that’s why a company like Sharebuilder has a lot of potential (as it makes that process easier) and is probably why ING bought them.
8 Jon Chevreau // Dec 6, 2007 at 4:33 pm
Just to clarify, I gave up writing an annual mutual fund guide but didn’t give up on owning them personally altogether. The same blog entry mentioned I own (actually my wife) AGF Precious Metals Fund but I do own the Sprott PM Fund, Trimark Fund and a bunch of DFA funds too.
9 Dave from GP // Dec 6, 2007 at 5:28 pm
I guess they must buy into the sales pitch. My mother recently retired and had asked me what she should do with her money she had from sale of her home and her mother’s who had recently died. She knew I was looking after my own finances thru TD Waterhouse, so I told her all about setting up an account. Her risk tolerance was pretty low so we discussed laddering bonds or investing in bond funds etc. I told her about MER’s ,commisions to the “advisors” etc. Earlier this year she suddenly announced that she had given it all to a mutual fund company because that was who my brother deals with and it seemed easier. Plus the sales person was really nice. I didn’t really say anything but it was shortly after that that the markets began their long decline. They may be in for a shock. Oddly enough I was considering buying stock in the same company she has her money with!
10 Canadian Capitalist // Dec 6, 2007 at 8:24 pm
Jon: Thanks for the clarification. I did mean you gave up writing but reading it again it didn’t come out too well.
For the record, I own one mutual fund: Leith Wheeler Canadian Equity. The reason is it is that it is one of the funds available through a Group RRSP at work and the index option I have is just a smidgen cheaper, so I opted to buy into a fund whose philosophy I could buy into. The fund MER is just 0.8% compared to 0.65% for the comparable index fund.
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12 Richard // Dec 7, 2007 at 2:04 pm
It’s a bit funny to say
“Fans of actively managed funds will often defend the hefty management fees associated with mutual funds by saying that active management shines when markets turn volatile. That is when money-management expertise can steer dollars away from obviously overvalued, over-hyped sectors and into areas that should perform well.”
when you consider that the best way for a fund management company to get people’s money is to have a fund in an obviously overvalued, over-hyped sector. But I guess before the end of the internet bubble people just wanted to get in on tech stocks that weren’t over-hyped.
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14 Annonymous // Dec 11, 2007 at 10:35 am
Jon,
It is interesting that you disclose your ownership of mutual funds. It is suprising that you do not own ETFs since you often write about them in your column and/or blog.
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