Mutual Funds vs Portfolio Management

Mutual Funds why are they still popular despite high fees and poor performance?

Many Canadians still hold their investment assets in mutual funds. This, in spite of a decade of lacklustre performance and high fees. Even the emergence of exchange traded funds (ETF’s) has failed to put much of a dent in the mutual fund industry. As of November 2013, mutual fund assets in Canada were $986 billion; Canadian investors held only $62 billion in ETF’s.

Brokers mutual funds sales commissions trailer fees invisible clients

Brokers like mutual funds because they are paid sales commissions and ongoing trailer fees that are invisible to their clients.

Before describing how portfolio managers work with their clients, let’s take a quick look at how mutual funds function. A mutual fund is an investment vehicle that is made up of funds collected from many investors. The manager invests those funds in securities such as stocks, bonds, money market instruments and other similar assets. Individual investors own units in the funds in proportion to the amount they have invested.

While the first mutual funds were founded in the 1930’s, they grew in popularity beginning in the 1960’s. In an era of high trading commissions, their main benefits were that they gave small investors access to professional management and diversification at low cost. With the advent of discount brokerage in the 1980’s and ETF’s in the past 10 years, mutual funds are no longer a low cost option. With many large Canadian mutual funds still charging fees in the 2% to 3% range, they are now an expensive way to invest.

Why have many mutual funds performed poorly? High fees are certainly one reason. Another is that mutual funds tend to be over-diversified. Larger funds have so many assets (i.e. so much cash to invest) that they have to hold hundreds of stocks. This can make it difficult for funds to outperform market indices.

Despite this difficulty, brokers and fund managers feel that clients expect them to out-perform the market. To do that they are forced to take on more risk. However, if a fund out-performs in a rising market, it will likely under-perform in a declining market. That is exactly what many Canadian investors experienced in 2008: while the TSX Composite Index declined by just over 30%, many supposedly ‘conservative’ large-cap equity funds declined by 40% or more.

Given the poor performance of many large Canadian mutual funds, why do so many investors continue hold them? Brokers like mutual funds because they are paid sales commissions and ongoing trailer fees that are invisible to their clients. It is also worth noting that there is growing evidence suggesting that the sort of people most likely to go into the lucrative financial service sales roles are precisely those least suited to judging risk. Read more here>>

What’s the difference between a portfolio manager and a broker?

It is a source of pride for us that we are discretionary investment managers, not brokers. We are independent of any bank or broker and our only source of revenue comes directly from our clients. We do not receive any kind of commissions or trailer fees. Sprung Investment Management is committed to meeting a fiduciary duty. A fiduciary duty or best interest standard (already the norm for doctors, lawyers and some other professionals) is a legal requirement that an adviser must put the client’s interests first. That includes avoiding all conflicts of interest and making the best recommendations for the client even if it means lower compensation.

Canadian securities regulators are reviewing the potential benefits of introducing a fiduciary standard for brokers. Their industry body, the Investment Industry Association of Canada (IIAC) is fighting against this proposal. Learn more here>>

At Sprung, our investment management approach is based on the value investing principles developed by Ben Graham.  Graham explained that “the essence of investment management is the management of risks, not the management of returns.” Learn more here>>  The management of risk begins when a new client joins us. Clients meet directly with Michael Sprung and other members of our team. We take the time to get to know our clients in order to understand their investment objectives and risk tolerance.

Based on that understanding, we begin to build a portfolio that includes high quality dividend-paying stocks and Canadian government bonds. Whereas mutual funds often hold hundreds of stocks, our client portfolios typically hold 20 to 25. We believe this is a sweet spot for diversification. If you hold more, gains in any single stock will hardly affect the total value of your portfolio. If you hold fewer, losses in any stock can have an adverse effect on your portfolio.

In summary, the benefits of portfolio management include:

  • A personal relationship with the person who is actually making investment decisions on your behalf;
  • Holding a well-diversified portfolio that properly reflects your risk tolerance and investment objectives;
  • Avoiding the conflicts of interest inherent in the broker/ fund manager model;
  • Transparency—no hidden fees or commissions;
  • Lower cost.

OSC Reviews Relationship Between Advisors and Clients

OSC – CSA Consultation Paper 33-403 Proposes to Impose a Fiduciary or Best Interest Standard on All Advisors

In response to this proposal we have made the following submission to the OSC

The CSA is reviewing the potential benefits of introducing a statutory fiduciary, or ‘best interest’, standard for securities advisors when they provide advice to retail clients.

OSC roundtable best interest duty investments advisors

The OSC held a roundtable last summer to discuss imposing a ‘best interest’ duty on investments advisors.

The recent report by Laura Paglia of Torys LLP, written at the request of the Investment Funds Institute of Canada (IFIC) and the Investment Industry Association of Canada (IIAC) concludes, “there is no gap in Canada that need be or could be filled by imposing further statutory obligations on investment advisors and dealers.”

In our view, the discussion surrounding investment advisors and their clients has largely ignored the role that capital markets play in enhancing the well-being of the economy.  This role has several objectives, some of which may be in conflict with the objectives of many investors but are nonetheless necessary to allow capital formation and capital allocation to be directed in an efficient manner.

One of the most important roles of the capital markets is to provide a primary market that allows companies to form, raise capital to invest in productive resources.  This function of Initial Public Offerings provides a mechanism that allows the economy to expand.  Companies tend to go public either at very early stages of development or at times when the highest valuation a company can garner in order to expand is available through the public market place.  Secondary issues are also brought to market when management deems that they can get the best value in this manner.  This function often presents a conflict of interest between investment dealers and investors. Investment dealers, which generally include a lead underwriter and multiple other underwriters (also referred to as the sell side firm and the lead “book runner”, with “co-managers”), can take a cut of 3% to 7% of the gross IPO proceeds to distribute shares to investors.  When an advisor calls a client regarding an IPO is she acting in the client’s best interest, the best interest of the company that will receive the funds, or of their employer?

Another role that capital markets play is to provide an efficient market place for investors to buy and sell securities.  In this function, investors have a multitude of objectives ranging from pure speculation to saving for the long term.  It is unfair to categorise investors as one homogeneous group.  Most investment advisors are paid for piece-work; that is, they are paid by the volume of trades that they perform.  Again, this places their interests in conflict with many, but not necessarily all, investors.  Investors have a choice of the type of advisor with whom they can choose to deal.  Many advisors work on commission, but others work on a fee only basis.  Advisor/dealers working on a fee basis may still be in conflict with investor objectives if they are employed by a dealer whose objectives are volume related.

Much of the confusion to the investing public revolves around the fact that many investment industry professionals call themselves advisors or portfolio managers.  The distinction between an advisor/portfolio manager who must sell “suitable” investments and advisor/portfolio managers who meet a fiduciary standard is at best, murky.

There is a set of advisors that through extensive training and examinations, have the ability to manage investor funds on a discretionary basis.  Surely, people acting in this capacity should and must be charged with a fiduciary standard.  They should not be allowed to place themselves in a potential conflict with clients without extensive disclosure requirements.

Current advisors without this extensive training may not always appreciate the nuances of the best interest standard.

In our opinion, a revised regulatory framework should:

  • Make a clear distinction between individuals who meet a fiduciary or best interest standard and those that sell “suitable” investment product;
  • Restrict terms such as ‘advisor’ and ‘portfolio manager’ to individuals with the training and experience to act in the best interest of clients;
  • Prohibit those individual from selling products that present real or potential conflicts of interest, unless very extensive disclosure is present;
  • Indicate that other industry players, including financial planners selling mutual fund products, are selling “suitable” products and are in fact salespersons;
  • Disclose to clients detailed information regarding the remuneration all financial intermediaries.

Financial markets are vital to capital formation and the continued growth of the Canadian economy. The regulatory framework governing financial intermediaries must balance that positive role with the need to protect Canadian investors.

Michael Sprung – Submission Re CSA Consultation Paper 33-403


Ontario Securities Commission Considers Imposing ‘Best Interest’ Standard on Brokers

Ontario Securities Commission Considers Imposing ‘Best Interest’ Standard on Brokers

Ontario Securities Commission roundtable best interest duty investments advisors

The Ontario Securities Commission held a roundtable to discuss imposing a ‘best interest’ duty on investments advisors.

Last week, while investors were focused on US Fed Chairman Ben Bernanke’s comments about ‘tapering’ or reducing QE—and the market turmoil that followed, the Ontario Securities Commission held a roundtable to discuss imposing a ‘best interest’ duty on investments advisors. The Investment Industry Regulatory Organization of Canada (IIROC) that represents advisors, is against imposing a duty on firms and their representatives to act in the best interest of clients. Instead, IIROC suggests improving compliance with the existing ‘suitability’ standard.

To understand the difference between a ‘suitability’ and ‘best-interest’ standard, imagine you are looking to purchase a new laptop. You visit an electronics store looking for advice. The salesperson recommends a $1,200 model with an expensive extended warranty. This package generates the highest commission for the salesperson. The laptop is suitable—i.e. it will satisfy your needs—but it is likely not the best solution for you. Imposing a disclosure obligation is not likely to stand in the way of a motivated salesperson. On the other hand, if the salesperson were bound by a ‘best-interest’ standard, he or she would likely recommend a $500 or $600 laptop that would meet your needs.

You may not think the same thing can happen in your investment account, but consider mutual funds. The management expense ratio of mutual funds in Canada varies between 1% and 3% or more. (MER is the sum of the management fee plus trading commissions, marketing and legal expenses and other costs.) Imagine two funds that meet your investment objectives, one has an MER of 1.5% and the other 2.7%. The one with the 2.7% MER pays advisors more.   Both would pass a “suitability” test, but only the one with the lower MER would most likely meet a best interest standard.

The core of the problem is that financial sales people in Canada can call themselves advisors, regardless of their professional designation. Investors assume they are compensated for providing advice. In reality, most are paid commissions either by their employers or fund managers to sell products, rather than for providing advice. That is exactly why IIROC is resisting the imposition of a ‘best interest’ duty on investment advisors. Not only would it reduce advisors incomes, it would curtail the ability of firms to direct advisors to sell highly profitable products.

With IIROC opposed, it will likely take a number of years for the OSC to impose a ‘best interest’ duty on investments advisors.  How can investors protect themselves now?

It is a source of pride for us that we are discretionary investment managers, not brokers. Sprung Investment Management is committed to meeting a best interest or fiduciary standard. A fiduciary standard (already the norm for accountants, lawyers and some other professionals) is a legal requirement that an adviser must put the client’s interests first. We have no hidden relationship with any broker or fund manager. We receive no fees or commissions from any broker or fund manager.

Read more about our investment management approach here>>