August 12, 2008, 6:00 am

Answering to a Reader’s Comment on Mutual Funds

by: The Financial Blogger    Category: Investment, Market and Risk
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Friend or Foe? I don’t even know yet when I am talking about a Primerica ambassador called “V” (or is it V for Vendetta?). If you are curious about “V”, you should read comments following any of my Primerica posts. He(she?) pointed some good questions in his latest comment about Mutual Funds. I thought I would write a full post about as it will probably be relevant information for several readers. Here was the question:


“I hear a lot of people talking about the turnover ratio in mutual funds. How exactly does the buying (and more specifically) the selling of funds by clients, affect the overall performance of a mutual fund.

Another concern of mine is the whole issue surrounding MERs and fees associated with mutual funds. If my fund is reporting a 10% rate of return, isn’t that After the 1.5% or 2.3% MER has been deducted? Meaning, if a fund reports 10% rate of return it really did 12 %or 13% before fees were deducted? The reason I ask is because, if my fund is averaging 10% after fees, why do I care about the fees? 10% is 10%. Ultimately, that is the goal I am concerned with – hitting 10% or better on my overall performance. So, even if the MER was 5%, if the fund is averaging 10% over a 20 year period, should I really care?”

Turnover Ratio

There are actually 2 types of turnover ratio. The first one is related to the assets within the mutual funds. A higher turnover ratio means that the fund manager is trading more actively and changes his positions on a regular basis. If you believe in passive investing, this is probably not the right fund for you. The other impact is that you will have a lot of capital gains showing on your income tax form every year (unless he is losing money!). Since one of the major advantage of capital gains is to be reported in the future, there is not much incentive to cash in your capitals gains years after years.

When we are talking about turnover ratio in regards to the number of fund units being traded on the market, it has no or little influence on the fund performance itself. Most mutual funds are big enough to overcome daily trades and not to sacrifices good investment in order to reimburse holders of the mutual funds. It could affect the fund’s return if there are too many units for sell at the same time compare to the size of the funds. I guess you would see such phenomenon for small and private funds.

MER’s

MER’s in Canada is always an interesting topic since we are one of the countries with the highest management fees charged to clients. V, you are right to not care about the MER’s if your fund returns after them is over your investment objective. It is more important to achieve your investment goal than to focus on other aspects such as taxes or MER’s.

However, you have to be certain that your funds post after MER’s returns (some of them don’t). The other thing to consider is that those fees are always grabbing a part of your profit. Therefore, if they are too high, they might impact the long term performance of your funds. If you are paying a 3% MER’s and you barely makes the Index, it means that the fund manager is making money on your back and you simply get an additional risk compared to ETF’s.

I hope I answered all your questions, if not, please feel free to add your comments 😀

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Comments

It is also important to look at the Alpha and Beta. They can give a good indication on how the fund is doing with the current fund managers.

In short, the Alpha is how much value the fund manager(s) bring to the fund. The Beta is, in essence, how much risk the fund takes compared to an index.

Eg, a 1.0 Alpha means, on average, the managers bring enough value to beet the index by about 1%. I have seen a few funds that have an Alpha of 2 or greater. Not that many though.

A .6 Beta for instance means the fund generates it’s returns with about 40% less risk than the index it self.

In other words, a high alpha and low beta means greater returns with less risk than the index it is compared to.

[…] the other day’s column, there was a very interesting comment made by Richard about two additional things you would be […]

Thanks for the Post FB!

I do have a question. I guess when I was writing that quetion up, I was thinking about mutual funds with a sales force, vs funds that dont’ have a sales force or no load… Because people are always worried about our commissions as reps or the expenses associated with our funds. But there are huge benefits to having a mutual fund with a sales force no?

For example: Primerica is a Life Insurance company first, but we are a marketer of financial products: Mutual Funds, Debt Elimination programs, Legal advisors, wills etc. etc. Now, we are one of the largest marketers of mutual fund in all of North America. So, when a client gets into a mutual fund that is marketed by Primerica, don’t they have an advantage over someone who gets into a mutual fund by themselves?

Have you ever heard of “double dollar cost averaging?” We have all heard about putting money into an investment over time. As the market takes a downswing you are able to buy more shares and when the market is doing well, you buy less shares. So you get a smooth average of the good and bad years. I believe in this philosophy. But what about if your mutual fund is also dollar cost averaging?

Money Managers who over-see our funds are getting 30 Million dollars on Monday morning to invest in stocks/bonds (for sake of argument), and on Tuesday morning they’re getting another 30 Million, and Wednesday they’re getting another 30 Million and so forth… Because we (as Primerica reps) are investing and we’re educating our clients about why they need to put money away etc.

The “no load” manager who doesn’t have a sales force marketing his mutual fund isn’t getting 30 million on Monday morning. It depends on how people “feel”. If the market is doing good, people will put money in, and if it’s bad they’ll take money out. It doesn’t cost them anything to get into these funds so they just sell/buy shares whenever the feel like it. that doesn’t happen with our funds because clients are educated about dollar cost averaging and they have an advisor coaching them to put more money in when things get tough. On average, our clients stay invested in our mutual funds for at least 6 years (on average) before redeeming any shares.

This is what I was trying to refer to when I said “turnover.” Sorry for the confusion.

What is your take?

Cheers,
V

by: The Financial Blogger | August 20th, 2008 (6:26 am)

V,

First things first, some people will always be more concerned about how much you make in commission than how much they will make with the funds. We all have bills to pay and it’s normal that you are making money while selling a mutual funds 😉 It is unfortunate, but those people will not understand the structure and only think about their pocket.

I am not sure I understand your point about sales force. For example, most bank have “no load” mutual funds but they still have a sales force. I also believe in periodic investment and suggest it to my clients too.

Most funds are so big that they don’t really get influence by investment habit. Because even though you are getting all your clients on board with dollar cost averaging, you will also bring more massive amount of money when you transfer a client from another institution. Same thing if a part of your clients are transferring out or buy a property for example.

Fund managers have so much money to handle that daily fluctuation should not be that important in their investment strategy. HOWEVER, history saw many managers fail because they were too popular. They simply received too much money to invest within a short period of time since everybody wanted “the fund outperforming the market for the past 10 years”.

Do Primerica funds have back-end load fees? If so, that might explain why your clients are keeping their funds for 6 years 😉 Seriously, regardless of the fees, a good investor should keep their funds for at least 6 years in order to go through 1 full economic cycle. Unfortunately, most people panic after 6 months of negative results!

I guess this is how good investors make money 😉

V,

You are in reference to B shares for back end loaded funds. A shares are front loaded. If investing for the short term, A shares are better (the load is over with up front.) If investing long term, like many of the clients out there, B Shares are better since you will have more money being invested long term.

These are not specific to Primerica. All and all, the type of share (as well as fund(s)) should be decided based on the intentions of the client.

The shares I’m referring to are DSC (Deferred Sales Charge) so the charges decrease as time passes on. after (I belive it’s 5 or 6 years if I’m not mistaken) the charge to sell shares is waved. But this is not important

I was thinking… If a no load Mutual Fund Manager does not have a sales force pitching their fund (or a relatively small sales force compared to a company like Primerica or Investors Group) here’s what happens, correct me if I’m wrong:

When the economy is in a downward spiral like it is now, most people in a no load have not payed anything to get into them. So when they see their portfolio loosing money, without anyone to advise them otherwise they will pull out. When they redeem their shares, the fund manager must sell stock (to come up with the money to pay these people). As such, the NAVPS of the fund should fall significantly lower. So you have the market influences, as well as the sellling of shares contributing to poor performance.

when the economy is good, more people will buy no load funds based on the fact that there are no “fees”. Now the Mutual Fund Manager is getting money more money to buy stock, but he’s buying when they’re most expensive! (Remember, the market is hot) And if you remember above, he had to sell when the economy was bad… Logically, this does not sound right to me.

On the other hand, the mutual fund manager of the fund with a sales force (like Primerica) is receiving an influx of money to invest when the economy is performing badly as well as when it’s good. So the fund manager is actually buyin more STOCKS when they are cheap, and buying less Stocks as they get more expense when the economy recovers. In theory, this should boost the NAVPS of the fund when the economy turns around since the average cost per share is spread out over the neg/pos periods in the business cycle.

In my opinion, it makes complete sense to dollar cost average. But your mutual fund should ALSO be dollar cost averaging or else you’re wasting your time. It will be more difficult for the manager with a smaller/no sales force to out perform the market when more people are selling shares when the economy is bad, and buying when the economy is good.

Cheers,
V

The Mutual Fund manager of the no-load fund is essentially “buying high and selling low”

V

Deferred Sales Charges are also associated with B Shares (a few others, B are just most common).

And a point of note, I do agree with what you are saying.

by: The Financial Blogger | August 20th, 2008 (6:17 pm)

V,
Your arguments would be valid for very small mutual funds companies. I don’t know if there still several funds like that in USA but I highly doubt we have such funds in Canada.

No load funds are mostly managed by banks and other big institutions, Therefore, their funds are big enough to not be influenced by movements from clients. This would explain that major funds held by banks or companies such as Fidelity perform as well as funds managed with fees such as Primerica’s or Investors.

Another example would be Sprott Asset Management; It is a smaller mutual funds company with a small sales force. Their penalty is only applicable on the first 180 days (which is pretty small). At one point, the Canadian Equity fund was so popular that they simply closed (not issuing anymore new shares) in order to control the money held within the fund. It has a 10 years annualized return of 30% and 25% since inception. So even small funds with (virtually) no penalty fees can succeed pretty good.

I personally never read about any advantages from back end or front end fees mutual funds. I guess that if you invest over a long period of time (which is highly recommended if you want to make good returns) it won’t make much difference after all.

by: Aditee Dani | December 21st, 2009 (10:47 am)

Hi,
I am a beginer in this field so wanted to know a couple of things in mutual funds.

There are NAV graphs that show how a fund is doing, so wht is the way to see if it is doing well or it will fall,like the stocks tht have a zillion indicators and overlays to help one. so how do we judge a fund?

Secondly, is there an exit strategy for the funds, like the stocks?

Aditi

I am not sure I understand your point about sales force. For example, most bank have “no load” mutual funds but they still have a sales force. I also believe in periodic investment and suggest it to my clients too.