Mutual Funds

by Mr. Cheap

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A while back I was at a dinner with a bunch of people. A fetching young lady and I started talking finances (Mr. Cheap knnoowwwsssss what the ladies like…) and I referred to ETFs as “the thinking man’s mutual fund”. My father, who has been an avid mutual fund investor for decades gave me a bit of a hurt look, and I felt bad (I didn’t think he was listening to me).

I got talking to a buddy who, on the advice of HIS father, was hot-to-trot to invest in a Spectrum mutual fund. I told him to get a diversified group of ETFs instead – pointing him towards Canadian Capitalist’s “Tour of ETFs” and “Sleepy Portfolio” (as well as Money Sense’s couch potato portfolio). When I told him that a diversified ETF portfolio should average a 10% nominal return over the long haul (this is retirement money he’s looking to put away), he asked why he’d settle for 10%, when the Spectrum fund had averaged 36% over the last three years.

One of the best things about teaching someone something is that your fundamental assumptions are occasionally questioned. It can be a great way to expand your understanding in a direction that you didn’t even realize you were deficient in if you’re unable to answer their question (in which case you should probably go educate yourself until you can answer their question).

My response to him started with the idea that past returns don’t guarantee future returns. I talked a bit about mean reversion (the idea that often an area that has been recently hot may go into a slump in the near future, or an area that has been in a slump may take off). He agreed with this in theory, but then asked “isn’t the manager a smart guy who knows how to move in and out of areas to make lots of money, leading to an ongoing above-average market returns?”.

I agreed that this was usually the story mutual fund companies liked to sell, but I talked about how research had shown that mutual funds UNDERPERFORM the market on average. Since people aren’t just randomly chosen to run mutual funds (these are all professional investors), it makes the whole system pretty suspect if the average PROFESSIONAL can’t beat the market.

I followed this up with the problem of popular (high performing) funds attracting lots of money, and how its harder to get high returns once a fund gets too big. The basic idea is that if they find a good deal, they can’t buy as much of it (as a proportion of their portfolio) as a small fund could. It may be worthwhile for an individual to shop at garage sales for bargains, but it doesn’t make sense for Walmart to do this (they wouldn’t be able to find enough bargains to stock their shelves).

Following closely on the idea of big funds having trouble outperforming the market, I talked about how mutual fund companies start a large number of “incubator” funds. They let the managers of these small funds take whatever crazy risks they want. The hope is that some of their funds will wildly outperform the market (and, of course, if you have enough funds doing different things some will), they then promote that fund as their “flagship” product, promote its amazing returns in all the financial papers / magazines, roll over the poorly performing funds into it (and get tons of new investors in it). Since they know at this point they probably won’t keep getting lucky again, they then track the market as much as possible (so they don’t lose tons of money and annoy all the new investors), and prepare the next batch of mutual funds to create the “hot fund” of the future.

For some strange reason, these monsters funds tend to give you a return of [market - expenses]. Isn’t that curious :-).

At this point, ETFs offering [market - small expenses] look appeals, and that’s what I recommended buying. My friend still seemed somewhat hesitant, and I encouraged him to talk to his father further. I offered to buy him a copy of “Four Pillars of Investing” but he immediately told me under no circumstances would he read it. I felt kind of bad that I hadn’t been able to convince him of the value of ETFs, but the next time I saw him I asked him if he’d bought the Spectrum fund and he told me “No, I’m looking into ETFs”.

For those who used to invest in mutual funds and stopped, what convinced you to bail on them? If you’re a fellow ETF / Index Fund evangelist, what do you like to say to people to convince them to consider ETFs? If you’re a mutual fund fan, which parts of this post do you think I’m mistaken about (remember that “you’ve got it ALL wrong, mister!” is often a fair response to Mr. Cheap’s rants).

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{ 26 comments… read them below or add one }

1 Four Pillars

I don’t usually bother – to get someone from the “what the best fund/stock to buy” stage to passive investing requires more than a quick dinner conversation (for me at least).

So maybe more dinner conversations are required for the fetching young lady??

2 Canadian Capitalist

Thanks for the mention. Like Mike says it took me years to become convinced that passive investing is the way to go. You’ll need more dinner conversations with the fetching lady!!!

3 Paolo

Can you fix your link for “Tour of ETFs”? It brings you to a 404 page. Thanks

4 Leslie

Mutual funds’ posting of sterling returns is also based on survivor bias http://www.investopedia.com/articles/02/013002.asp

Very similar to history is written by the victors.

5 Four Pillars

Paolo – thanks, I’ve fixed the link.

Leslie – very good point about survivorship bias – this definitely affect the aggregate returns for mutual funds.

6 Mike

One of the best posts I’ve seen in a while. Thanks!

Also thanks leslie for an awesome link.

7 mariam

What got me out of MF investing is the fact that my financial adviser foisted unproven MFs on me. These were brand new with no track record. They say you should also investigate who is the fund manager and if he/she has a proven track record. Mine was someone who had a sociology degree or some such.

So now I’m supposed to find a good financial adviser AND read up on well managed MFs? Thanks for taking my money while I do the work.

8 Four Pillars

Thanks for the comment Miriam – the fact is that unless you have big bucks to invest – most FAs won’t give you the time of day other than to take your money, throw it into a back end fund and then call you every February :)

Mike

9 Kim

Your only argument for ETF’s is that they cost less?

And your argument that large Mutual Funds can’t buy as much as they want is myth. Show me one Mutual fund that couldn’t get enough liquidity. If it comes down to it, companies will issue shares/warrants if need be. Some of them will even cross huge blocks over for mutual fund buyers.

They have advantages that we retailers can only dream of. They have professional buyers/sellers that can help them trade into a price range that’s good for them. Mutual funds put the M in MM.

10 Leslie

Kim, the lower MER on ETFs isn’t their only virtue. I’d add, off the top of my head, tax efficiency and better asset allocation. Mutual funds also carry a cash position to allow for redemptions–I’d be darned if I’m going to pay a MER on management of cash. What is more, mutual funds have routinely been shown to have no better returns than an index fund despite the professional money manager at the helm of the MF. Certainly there will always be MFs that do better than the index but as it is not *always* the case then a person is better off using ETFs in a couch potato portfolio.

11 WoolyWoman

God I know I am being soooo lazy right now with my investments, concentrating on debt, but reading this makes me think maybe I am being a bit naive (oh yes I got mutual funds). Thanks for the post thats getting me thinking!

12 telly

I’m an avid ETF investor but I must admit, after reading Rob Carrick’s new book “How to Pay Less and Save More For Yourself…”, I’m actually considering parceling off a portion of our RRSP for low MER mutual fund investment. Rob describes how low MER mutual fund investing can be advantageous in a bear market.

My idea is that, with a decent size portfolio with little to no fixed income, it might be worth allocating a percentage to mutual funds to lessen the volatility. Just an idea. Despite your love of ETFs, it might be something to consider a post on perhaps. I’m curious what others think.

13 Mr. Cheap

telly: I’m not a fanatic, if someone realizes these issues, thinks there’s a part of their asset allocation that a specific mutual fund still makes sense for, power to them! I just think a lot of people who blindly buy mutual funds would do better blindly buying ETFs :-)

Sounds like an interesting article (I like most of Rob’s stuff). I’ll try to track it down, thanks!

14 telly

“I just think a lot of people who blindly buy mutual funds would do better blindly buying ETFs”…I whole-heartedly agree.

It’s actually a book. I could send it to you (it’s a quick read) if you promise not to accidentally put it into a book give-away. ;)

Drop me an email if you’re interested. Most of it is basic stuff but there’s somegood stuff in it as well.

15 Four Pillars

Telly – we will definitely be giving it away but don’t worry – your odds of winning will be VERY good. (wink, wink).

Interesting point about diversifying with mutual funds.

It’s true that in theory you can buy mutual funds that will diversify your ETF holdings and can decrease volatility but you will have to do the research to make sure that the funds you buy are indeed doing what you want them to do.

I’m not sure how easy this is to do with Canadian equities – obviously most of the big funds are index huggers so they won’t do the job. You would need to look for funds that are different from the major indexes but not so different that they increase volatility (ie resource funds).

An broad market index should encompass all investment styles such as growth, value or any combination. Adding funds (or even specific ETFs) that use a certain style might increase your volatility (and losses) when that particular investment style is not doing well.

My personal opinion (and yes, I am an ETF fanatic) is that short term fixed income (in a tax sheltered account only) is the way to reduce volatility.

I’d be interested in reading the book and thinking about this topic more.

Mike

16 Four Pillars

Just thought of a couple more things.

As I said it might be hard to buy a fund to diversify efficiently but a couple of ideas are:

1) buy puts on the index – might be a pain in the a$$ but this will reduce volatility.

2) buy that new bear fund – I think it moves 2 times the direction of the market or something like that. Even a small amount will reduce volatility.

17 telly

“Itís true that in theory you can buy mutual funds that will diversify your ETF holdings and can decrease volatility but you will have to do the research to make sure that the funds you buy are indeed doing what you want them to do….obviously most of the big funds are index huggers so they wonít do the job”

Good points, and Carrick does mention this. He makes some recommendations, including a few I’ve often considered (PH&N funds).

I’m pretty much an index junkie as well so it’s just a thought in my head right now but as we’ve discussed previously, my husband and I plan to own little to no fixed income until the mortgage owing is < 20% of our total assets.

I must admit, I haven’t a clue what a put is. The new bear fund is a good idea that I hadn’t really considered but I don’t know that it has the same effect as what Carrick is proposing (though it might actually be better!)

18 Four Pillars

A “put” is an option on a future sale of a security.

For example if you own BCE and it is trading at $35 and you buy an April 1 $32 put then that’s an option to “sell” BCE on or before April 1 for $32. If the price of BCE never goes down then the put expires worthless so you’ve lost the cost of the put (they tend to be cheap) but your BCE stock has gone up.

On the other hand if BCE drifts down to $30 then you should be able to exercise the put and make $2/put which will help offset the decrease in BCE price.

This sort of trading will reduce your upside as well as your downside (ie reduce volatility).

19 Dividends4Life

That was a very interesting read. Over the last year I have began heavily using ETFs in my portfolio. I plan to include your article in my weekly carnival review this Friday.

Best Wishes,
D4L

20 squawkfox

Years ago I invested in mutual funds. Back then I knew nothing about investing, and was happy to give control to a “professional advisor”. I moved my money over to DIY index funds when I learned about MERs, trailers, and loads. I am always astonished when I compare the cost of the average mutual fund with an ETF or index fund.

I enjoyed reading about your dinner ETF discussion with friends. I too have tried to discuss passive indexing with my family and friends only with negative results. Apparently, my acquaintances don’t like hearing about how dearly they pay in fees. How do you approach the subject with them? My intention is always to help. :)

21 Four Pillars

SF – good work on getting into low cost investing!

Mike

22 Ranv

Good post but I’d like to mention one minor detail. While ETFs do have lower expense ratios than Mutual Funds, they may not end up being cheaper investments because of the brokerage fees and commissions on ETF purchases.

Despite this, I’m thinking of setting up an RRSP account that is comprised of index ETFs (iShares to be exact). I’m having a bit of trouble choosing a discount broker and I was wondering which brokers you all use?

23 Four Pillars

Hi Ranv – I use Questrade (type in the name in the search box for my posts on them). Mr. Cheap uses E-trade.

We’re both happy with our brokerages but Mr. Cheap says that E-trade’s $20 commissions are too high.

Mike

24 Ranv

Thanks for the advice, I’ll check out Questrade. Great blog by the way.

25 Four Pillars

Thanks!

26 David Hosten

I wonder how the ETF crowd is faring now? More specifically, the rational that well run managed funds do not perform on the upside, but on the downside is readily apparent in this brutal market. Indexers and ETFers are taking it on the chin, while good funds have protected on the downside…as they were always supposed to do. I still think that ETFs are a vital and valid part of almost any portfolio, but managing downside risk for retirees is an important part of my business, and I recommend asset mixes that include mutual funds, GICs, segregated funds, PPNs and segment their investments over time frame in addition to regular risk profile and asset allocation stuff. I could not in good faith recommend that one of my clients invest solely in ETFs, funds, bonds or equities. Diversity; the right kind of diversity is still key.

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