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.
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.