March 27, 2014, 5:04 am

Index Investing; Is It Always Better Than Mutual Funds?

by: The Financial Blogger    Category: Investment, Market and Risk
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Sometimes, I have the feeling that people think that managing their investments is as easy as making a peanut butter sandwich in the morning…

 

From what I’ve read in the financial industry for the past ten years, high management fees (called MERs) charged on mutual funds hurt a small investor’s portfolio. In fact, if we look at the Canadian industry, most investors pay about 2% (and sometimes more!) to invest in mutual funds. In other words, if you invest $1,000 and your fund make 5%, you only earn $30. The other $20 is paid to the mutual fund company to cover their management fees (and the advisor selling the fund). When you think about it, this is a 40% commission based your investment return.

 

It gets worst: imagine if the fund you invest in dropped -5% during a bad market. Your statement shows -7% or a loss of $70. Mutual fund companies will get their 2% no matter what, the rest goes in (or out!) of your pocket.

 

Unfortunately, mutual funds were, for a long time, the only way one can diversify in multiple products (company shares or bonds) managed by professional in a single trade. An investor could buy one mutual fund including a part of safer investments (like bonds), Canadian companies along with American and international company shares. For someone who doesn’t know how to invest, mutual funds are expensive but do the job.

THE ETF REVOLUTION

 

As is the case in any industry; when a product is overpriced or shows high profit margins, other players come to the market to offer an alternative. The first player to come with an alternative to mutual funds was probably Vanguard, one of the first ETF firms in the US. ETFs (exchange traded funds) are another way to buy multiple stocks (or bonds) with one trade.

 

Explained simply, an ETF is a group of investment products (mostly company shares or bonds) representing a “basket”. For example, the ETF iShares S&P/TSX 60 (XIU on the stock market) represents the 60 biggest companies traded on the Canadian market (the TSX). Someone buying 1 unit of XIU is buying a basket containing the 60 biggest companies traded on the Canadian market. He doesn’t have to know them, he doesn’t even have to manage them in his portfolio, the ETF does it all for him.

 

What’s the difference between buying a Canadian stock mutual fund or the XIU? About 2% in management fees! While most Canadian stock mutual funds will charge over 2% in management fees, the XIU fees are set at 0.18% (source ishares.com). Therefore, the portfolio manager taking care of the mutual fund must outperform the ETF by 2% before generating $1 for the investor. Here’s a quick example:

Investment Fees Investment Return Net Return $1000 Invested
Mutual Fund

2.18%

5%

2.82%

$28.20

XIU

0.18%

5%

4.82%

$48.20

 

As you can see, there is a big discrepancy between the mutual fund and the ETF even if they show the same investment return (before fees).

 

SO WHY DO PEOPLE STILL INVEST IN MUTUAL FUNDS THESE DAYS?

 

Here’s my answer: because it’s harder to manage your portfolio than it is to make peanut butter sandwiches!

 

Then, some people will suggest a “coach potato” investing style. The coach potato approach is to select a few ETF indexes that reflects your risk tolerance. Let’s say you want a balanced portfolio (roughly 50% in the stock market and 50% in bonds). You could build a portfolio with only 4 ETFS:

50% in a bond ETF replicating the DEX universe (Canadian bonds in general)

25% in an ETF tracking Canadian stocks

15% in an ETF tracking US stocks

10% in an ETF tracking International stocks

 

I agree that pretty much anybody with a calculator, a sheet of paper and a pen can build such portfolio. Then, you rebalance your portfolio twice a year to make sure you always show the same % (sell high, buy low). That’s a pretty effective method to manage your portfolio and track your investment return to the markets (95% of portfolio managers don’t beat their benchmark on the 5 year return). On top of this, your management fee is under 0.50%… this is at least 1.50% cheaper than the same investment in a mutual fund. If you invest $100K in this portfolio, you save $1,500 per year just in fees!

 

But it’s not that easy. Nope: managing your portfolio is not that easy.

 

HERE’S WHAT HAPPEN WHEN THE GAME CHANGES

 

Last years, bonds were paying a ridiculously low interest rate and bonds started to lose value upon the rise in interest rates. This is why XBB (a Canadian ETF tracking bonds) shows a negative return of -2.37% over the past 12 months. Add the bond interest rate paid by this ETF (3.26%), you get a small investment return of 0.89%.

 

How can you explain that most mutual funds did better with their fixed income (bond) portion? After a good talk with a friend of mine who’s a super fan of ETF investing, I noticed that his bond performance weren’t that great over the past 3 years. This was mainly explained by the poor Canadian bond returns.

 

At first, I assumed it was the same environment for everybody… until I checked a few mutual funds performance records. Most mutual funds show better returns during the same period… how can this be possible? It’s not because portfolio managers were better. It’s because they included other classes in their fixed income portfolio such as high yield bonds, international bonds and US bonds. This is how, for the past 3 years, mutual funds are able to beat a classic coach potato portfolio: because they include several other investment classes.

 

YEAH… BUT YOU CAN REPLICATE THE SAME MODEL WITH ETFs

 

It is true that if you had replicated the exact same model with 8 or 10 ETFs, you would probably have beaten the mutual fund. But here’s the thing: who is going to tell you how to make such a portfolio if you adopt a coach potato investment style? Not your online broker, he simply performs the trades. Not your advisor because you don’t have any. Your neighbor? Maybe.

 

I guess now you can see where the problem with ETF investing lies: you still need a good financial background to build and manage your portfolio. If you do it only after reading a few books, chances are that your investment returns will be lower than mutual funds even after their huge fees.

 

I wouldn’t risk opening the hood of my car to start working on the engine to solve a problem, I wonder why people think it’s that easy to invest money…

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Comments

I’m trying to get more information mutual fees and EFT’s. This article has helped me, thank you.

So if I understand you correctly, you are saying 1 EFT does not a portfolio make. You need to diversity with other EFT’s. I have my TFSA in SCOTIA CANADIAN DIVIDEND FUND which I believe is a mutual fund and had been wondering if I should change ti ton an EFT, due to the high fees.