The Staying Power of Mutual Funds

Mutual funds are ingrained in nearly all retirement portfolios, whether we’re talking about RRSPs in Canada or 401(k) plans in the US. They’re so ingrained that in the US, most of the operational systems used to invest client funds can only handle mutual funds because they are designed to settle 1 day after a purchase or sale, whereas other products such as ETFs and stocks settle 3 days after a purchase or sale. When operational limitations like this are the biggest challenges to new products entering these retirement portfolios, instead of the actual merits of the product, you know the incumbents will not be giving up share to ETF issuers easily.

The Numbers

When Preet gave me the opportunity to write something for the readers of WhereDoesAllMyMoneyGo.com, I decided I’ll start by presenting the most important facts people need to know about the mutual fund versus ETF debate.

Canadian mutual funds are considered to have some of highest fees in the world. This was first concluded by a study in 2007. Canadians on average had to pay an expense ratio of 2.56%, compared to 1.29% worldwide and 1.11% in the US. This is largely a product of the oligopoly that is the Canadian mutual fund space, with the 5 major banks taking up the biggest market share. Here’s what this means in $ terms. The chart below shows you what two portfolios, one using ETFs and one using mutual funds would look like over 20 years, with markets providing a 5% annual return. I’ve given the mutual funds the benefit of the doubt by using a 2.20% expense ratio, assuming they would have become slightly more competitive since 2007. And I’ve used a 0.75% expense ratio for ETFs. The difference in fees creates a final difference of more than $5,300 on a portfolio that started off with $10,000.

What’s keeping mutual funds in their place?

What I’ve presented above is not news to anyone reading this article, the benefits of ETFs have been clear and well-discussed on this blog and many others since ETFs really took off in the last few years. But despite this, the penetration of ETFs into traditional portfolios has been slow. I have a theory on why that is, and why that might be about to change.

The superiority of ETFs was confirmed in 2009 when for the first time assets managed by Index ETFs overtook those managed by index mutual funds. But take note, this progress was restricted to the passively-managed space. Passive or index mutual funds make up only about 10% of all mutual funds, with the other 85-90% being actively-managed. Which brings me to my point – despite years of debate on the inability of active management to provide any benchmark beating returns, investors have continued to pile into active funds. This I believe is due to investors just not being satisfied with index returns.

People like to put their faith in a star manager whom they believe can do well, and faith is an often underestimated quality. People want a knowledgeable market expert to at least attempt to beat the market, rather than settle for the market return. Given an offer to receive a guaranteed $25 or a 10% chance to receive $200, most people will take the chance even though the math is against making that choice, because they believe in themselves to beat the odds. And this is what we see in the active versus passive debate as well, where investors believe they can choose the market-beating manager. With most people looking to invest their money in active strategies, ETFs haven’t been an option because of their passive nature even though they are cheaper and more tax efficient etc. But that’s changing.

Actively-Managed ETFs enter the stage

Actively-Managed ETFs differ from traditional ETFs in that the money you put into these products is actually managed by a portfolio manager practicing active management, attempting to beat the market and their benchmark, just like every active mutual fund. So in essence, Active ETFs now provide those investors looking for active management (which is most of them) the option to get what they are looking for through an ETF structure.

Active ETFs debuted in the US in 2008 and in Canada in 2009. Today, there are 5 providers of Active ETFs in the US and 1 in Canada. Head here for a complete listing of current actively-managed ETFs. Most of these products are managed by stars from the active space that investors can put their “faith” in.

What all this means is that finally, both categories of investors, those looking for active managers and those just looking to follow an index, have a way to invest through ETFs and benefit from the 4 main advantages that they bring. Mutual fund issuers might have just lost their monopoly on the last carrot they had been able to dangle in front of investors all this while – the promise of active management.

Thanks Shishir – some good points to consider. I’ll add that the long-term fee impacts are magnified when using a lower cost index ETF portfolio which may have a blended portfolio MER of lower than 0.75% – which makes it all the more compelling.

Related posts:

1. Growing Active ETF Market Means Mutual Funds Should Consider Allowing F-Class Units For Sale Through Discount Brokerages
2. Almost $250 Billion Invested in Closet Index Funds in Canada
3. Active Funds Protect In A Down Market… Debunked

Charles Schwab also offers commission-free trading on their own lineup of proprietary ETFs, but I don’t believe they have any fixed income offerings. Their equity index ETFs are a bit more limited than the commission free list of iShares being offered by Fidelity as well.

Take a look here to see the details and ETFs available. Remember, this isn’t available for Canadians. We’re special.

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1. Real Estate Agents Adopt Hedge Fund Commission Structure
2. New Canadian Small Cap ETF Available
3. TFSA Tax Free Savings Account Strategies

The W Network has extended the submission deadline for the 2010 W Expert Search until February 22nd. Click here to see the videos of the accepted applicants so far – and don’t by shy! You still have time to put a video together and enter!

From Around The Blogosphere

Thicken My Wallet wonders how long you should give a financial advisor before you decide to terminate them. Hasta la vista baby.

Jonathan Chevreau notes that the 50-plus crowd is sitting on $300 billion in low-growth investments.

Rob Carrick believes that the new mortgage rules won’t hurt homebuyers.

Canadian Capitalist finds more evidence that investors are masochists.

Million Dollar Journey is giving away a bunch of free copies of Ufile – you have until Saturday at 5pm (EST) to enter.

Four Pillars gives some reasons why you would want to use a real estate agent. Shocking.

Michael James on Money explains how his struggles with GoodLife Fitness ultimately came to an end. I doubt it’s this smooth for most people.

Big Saving Man reminds us that it is RRSP season.

This Week’s Racing Video

11 minutes of ecstasy. Old rally cars, no music and full engine sounds. Love it. Enjoy! (Feed readers and Email subscribers can click here to see the video.)

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Theoretically, if you follow the tax code to the letter, and you know about every possible credit and deduction available to you, you should end up with the same refund/amount owing no matter what method you use to prepare your taxes. In practice, the number can vary quite a lot. Variations in results tend to be due to the quality of the preparation, and with tax software, that comes down to how questions are asked, the interview process, the optimizer tools and the types of support available to the customer. Regarding the latter, QuickTax offers the best support in the business with free phone, email and chat support on all paid products, Live Community and the Ask a Tax Expert option with QuickTax Online. Last year more than four million Canadians counted on QuickTax to get every penny they deserve by ensuring that they have the best possible information relevant to their specific tax situation.

Last year QuickTax introduced the Maximum Refund Guarantee. Users who get a bigger refund using any other tax preparation method can get their money back. It’s that simple. The typical Canadian wants to get their taxes done and be confident that their return’s accurate and they’re getting back getting back every penny they deserve. That’s what the Maximum Refund Guarantee does.

In addition, Intuit offers the 100% Accurate Calculations Guarantee. If you do pay a penalty or interest because of a QuickTax calculation error, we will reimburse you the penalty and interest.

*Note: I am not being compensated by Intuit nor do I have an opinion on the product – I’ve never used it myself.

Contest Rules:

• You may earn one entry by leaving a comment at the bottom of this post on the website.
• You may earn a second entry by re-tweeting the contest. If you have a twitter account, just click here. It will take you to your twitter homepage and all you have to do is click the “update” button.
• I reserve the right to delete any comments that are inappropriate.
• You must submit a valid email address in the comment form. Don’t worry, it will not be visible to anyone but myself and it will never be shared or sold to anyone either.
• Winner must answer a skill testing question.
• Entries must be submitted by 11:59pm on Friday, February 19th, 2010.
• Winners will be contacted using the email address provided only, and will have exactly one week from that point of contact to provide their full contact details in order to claim their prize.
• I reserve the right to disqualify any entries for any reason.

Related posts:

1. Giveaway: Four Copies of TurboTax Canada
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3. Giveaway: Wall Street on DVD (7 Copies)

1. Borrowers will be tested on their ability to make payments on a five year fixed-rate mortgage, even though they may choose different terms (e.g. a three year variable mortgage). Currently borrowers are tested against a three year fixed rate mortgage. This means people will qualify for lower maximum mortgage amounts. This will protect people from taking out larger mortgages than they can really afford. What some people are doing is opting for variable mortgages (with lower payments) and this exposes them to the risk that gradually increasing interest rates over time (because interest rates can really only go up from here) will make their mortgages unaffordable later on because they bit off more than they could chew up front.
   
2. The maximum a mortgage can be refinanced has been lowered from 95% to 90% of the value of the home. This reduces how much a borrower can tap into the equity of their house.  Again this will curb the ability of people to stretch themselves too thin.
3. Mortgages for homes in which the borrower will not occupy will now require a 20% down payment. It was 5% previously. This reduces speculation in residential real estate since borrowers now have to put up serious money in order to buy.

It should also be noted that these rules apply to those seeking CMHC insured mortgages (or an equivalent private sector mortgage insurer). So if you can find someone willing to offer you an uninsured mortgage you don’t have to worry about these rules.

In the end these seem like very prudent moves by Flaherty. The government doesn’t need to risk dollars insuring risky mortgage behaviour and those who are overextending themselves unwisely. In addition, these measures will hopefully make the Canadian lending industry that much more resistant to what happened in the United States in 2008.

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1. Holding your own mortgage inside your RRSP
2. Interest Rate Swap Dealers and Comparative Interest Rate Differentials
3. Mortgage Basics Part 1

A firm based in Toronto has set up shop to compete with the banks in fulfilling the currency conversion needs of customers. Their goal is simply to reduce the spread, which translates into more money in the customers’ hands at the end of the day, and a slice of the pie for the firm. They would earn less than a big bank, but it’s a business of volume and there is a big pie out there.

The President of the company is a reader of this blog and I asked him to answer a few questions to share with the readers. This is not a sponsored post, nor an endorsement – just thought it would be of interest. Here are the questions I asked, and the answers as given by Rahim Madhavji, the President of Knightsbridge Foreign Exchange Inc.:

1. Explain in a nutshell what you do.

Knightsbridge provides better than bank foreign exchange rates (and free wire transfers) to individuals (i.e. foreign property buyers, estate transfers, car/boat, and other large personal FX requirements) and small and medium sized businesses.  Knightsbridge provides its clients the level of service banks provides to its largest clients (market commentary, unique understanding of FX requirements, FX rate alerts, market orders, risk management policy development, and hedging tools – ability to lock in an exchange rate today for the future).    When dealing with a bank, customers often speak to a “representative” that does lending, mortgages, visa, chequing accounts, etc.  All we do is foreign exchange – we have to be better than the bank – otherwise no one would use us.

2. How are you able to provide better rates than banks?

Banks have a monopoly and significant market share.  As a result, they charge high currency margins.  Banks don’t pay much attention to the small business banking market.  Knightsbridge’s management team has strong relationships with financial institutions (Knightsbridge’s CEO is the former global co-head of RBC’s FX sales and trading group), which allows Knightsbridge to obtain superior pricing.

3. Why don’t more firms do what you do?

Currently, there are several competitors in the marketplace, especially in the UK, and there are several regional participants in the U.S. and Canada. However, due to stricter anti money laundering and terrorist financing legislation, barriers to entry for new participants are increasing. Because banks ultimately provide foreign exchange and liquidity services to all market participants, they are selective with whom they work with, and do significant diligence prior to allowing companies such as Knightsbridge to partner with them. Knightsbridge’s primary banking relationship is Bank of Montreal, and all client funds are held with BMO or other Canadian banks. Also, Knightsbridge is regulated by FINTRAC.

4. Are you as safe to deal with as a bank? Why?

• Knightsbridge is a foreign exchange and payment company – as funds are received they are sent to the beneficiary.  Think of PayPal, Western Union, but much better FX rates and no wire transfer fees.
• Knightsbridge does not hold deposits on behalf of clients.  Client funds are sent to the beneficiary, generally, by the end of the day.
• Strong management team.  Rob Wittmann, CEO of Knightsbridge, has over 30 years of financial services experience and is the former Global Co-Head and Managing Director of RBC’s FX Sales and Trading group.
• Rahim Madhavji, President of Knightsbridge, former investment banker at RBC and worked at a $550 million private equity fund.
• Michael O’Neill, Knightsbridge’s head trader, has 30 years of foreign exchange experience at global financial institutions.
• Knightsbridge is registered with and regulated by FINTRAC (Financial Transactions and Reports Analysis Centre of Canada).
• Knightsbridge’s primary banking and FX liquidity relationship is with the Bank of Montreal.  The Bank of Montreal has conducted diligence, including reviewing Knightsbridge’s comprehensive compliance policy, prior to establishing client trust accounts, payment, and a liquidity relationship with Knightsbridge.
• Knightsbridge’s works with TSX listed and private equity portfolio companies.
• Knightsbridge has no bank debt.
• Knightsbridge only operates on a “cleared funds” basis with clients (no settlement risk) and has policies and procedures in place to prevent fraud.
• Knightsbridge does not extend credit to clients.
• Knightsbridge does not take open market positions, and as a result is not exposed to market risk. All transactions are covered immediately (i.e. back-to-back). Forward contracts require margin to be posted to ensure against contract default.
• Knightsbridge has developed and provided a comprehensive, risk based Anti Money Laundering and Terrorist Financing Policy Compliance Manual to our liquidity providers and banking relationships.
• Knightsbridge has also developed a comprehensive business plan, which incorporates data backup and business resumption plans, as well as detailed client on boarding and transaction processing requirements.
• Knightsbridge and its clients are mutually bound by the terms and conditions found in the client application form.

5. What are the smallest and largest transactions your firm handles?

Minimum of $15,000 and maximum of $40 million.  Anything larger or smaller is on a case by case basis.

Related posts:

1. The Largest Bank Failure In The History Of The World
2. Liquidity of ETFs
3. RRSP Maturity or Conversion Options

So has everyone lined up their Valentine’s Day celebrations? I’m taking Fiona to La Bodega Friday night for dinner and then making dinner at home on Sunday. I used OpenTable to make the reservations and what’s nice about OpenTable is that you can accumulate points which can be exchanged for discounts at many restaurants with no enrollment fees. If you book a reservation during promo periods (which happen fairly often) you can earn 1,000 points. 2,000 points gets you $26 off your next visit to an OpenTable registered restaurant. I prefer booking online and it saves you money too – what’s not to like? It has about 130 restaurants in the Toronto area and about the same for Vancouver (not much utility for smaller cities yet though). Check it out here (not a sponsored link): OpenTable.com

From Around The Blogosphere

Jon Chevreau notes that the CD Howe Institute is calling for RRSP contribution room to almost double.

Rob Carrick covers an investment strategy some people are looking at for 2010.

Michael James on Money explains his problem getting Good Life to stop taking money from him. I recently spoke to someone at Good Life about a membership and tried to pay up front for a three month membership. They told me it would be cheaper to pay monthly and told me they would write “no termination fee” on MY copy of the contract (not theirs) so I would sign up for a 1 year term but be able to cancel after three months. I thanked them for the laugh and walked right out.

Canadian Capitalist discusses real estate agent incentives.

Thicken My Wallet gives you three ways to set yourself apart from other job-seekers.

Big Lovin’ Man explains Financial Valentine’s Day.

Four Pillars has A Numbers Approach to Finding True Love.

This Week’s Racing Video

Some funny crashes. The last one looks painful. Have a great weekend everyone! (Email/Feed readers click here)

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Considering that the US has traditionally been 50% of the world’s stock market (by size) it’s less of a stretch for Americans than it is for Canadians (Canada has traditionally been about 2 to 4% of the world’s stock markets by size). Some of the American financial advisors fell of their chairs during our discussion since it would be akin to an American investor putting their entire portfolio into handful of US mid-cap, industrial stocks (for example).

On the world stage, Canada is more akin to a small-cap and mid-cap market (there are only a few large cap companies on the global stage’s standards), and we all know our market is dominated by energy, financials and materials (they account for the vast majority of all companies by size in Canada – leaving out 7 other major sectors).

So why do we have such a home bias?

Partly because there is a slight tax advantage to holding Canadian stocks, but mostly its psychological. You tend to feel more comfortable investing in companies whose names you know and whose signs you see all the time. As reader Connie also points out, currency fluctuations between your home currency and foreign investments denominated in other currencies adds another variable to the mix (which can help or hurt).

Advisors and investors bring biases to their portfolios all the time. For example, I can tell you that investors and advisors who have immigrated from the Far East have 2x to 3x the allocations to emerging markets than born and raised Canadians. This is just from experience, I don’t have any stats to back that up empirically, but it’s true. :)

So what are the right allocations? Well, that would take a long time and is best saved for some future posts. There is no perfect allocation, but you do have to understand what risks you are exposed to with the allocations you take – and my point is that people, generally, don’t.

Related posts:

1. The Home Buyer's Plan (HBP): Borrow from yourself to help with home ownership
2. How Well Does Passive Investing Do In A Secular Bear Market?
3. Index Fund Tracking Error Sources

Why are there no DSC Index Funds?  On one hand, pretty much any advisor knows that there is no such thing as a DSC index fund and why that is so.  On the other hand, many retail investors probably never thought about it- and likely wouldn’t be able to accurately explain why this little wrinkle exists even if they did.  There’s likely a pretty severe disconnect on this- a topic that could have applications in the fields of practice management, ethics, client suitability and advisor ‘value propositions’ to name a few.

(Note: there actually are DSC Index funds these days, but they are far from ubiquitous – Preet)

In order to be clear, it needs to be underscored that mutual fund companies “manufacture” products, while financial advisors “distribute” them.  Obviously, no one could be expected to distribute a product if no one is manufacturing that product in the first place.  So, to modify my original question in the interest of specificity, “why don’t mutual fund companies manufacture DSC index funds?”

I’ll try to grapple with the question by confessing my concern right off the bat.  To me, this is a case of undue bias.  I would hope that all readers would agree that in an advisory relationship, the interests of the client should always come first.  Still, advisors are absolutely allowed (indeed, expected) to advocate for whatever products and processes they feel are best and are absolutely allowed to choose their own business model, too.

Many advisors insist that they are “independent”.   When asked by someone who understands the industry, however, one quickly finds that many “independent” advisors have an attitude that is similar to Henry Ford’s early take on car colours: “you can have any colour you want, as long as it is black”.  My take on those advisors who use mutual funds is that they effectively tell their clients that they suggest that they can: “have any mutual fund they want, as long as it pays an embedded compensation”.

This isn’t a topic that is confined to index funds, obviously, since there are dozens of credible actively-managed mutual funds available that never make it on to many advisors’ product shelves, either.  I chose to explore index funds because in the case of actively-managed funds, advisors can always find a similar fund that offers an embedded compensation and skirt the ‘advisor value’ conversation that might otherwise ensue.

The problem, as I see it, is when the business model drives the product recommendations to the potential detriment of the client interest.  The implicit premise of much financial advice is that the advisor is more likely than a layperson to reliably identify outperformers in advance.  Indexing drops all pretense of doing that.  As such, it begs the question of what one might reasonably expect from an advisor.  It has been suggested that the three primary functions of good financial advisors are to:

1. Spot problems and identify solutions.

2. Motivate people to act/change their behaviour.

3. Help people to emotionally detach from investment market events.

Notice that picking stocks and picking people who pick stocks (i.e. picking actively managed funds) is not on the list.  When talking about index funds that offer no embedded compensation, there’s no product alternative available today that has a similar mandate, but with advisor compensation built in.  In essence, advisors that use a commission model simply do not offer index products to their clients.

Obviously, the absence of a DSC index option would be a complete non-issue if actively managed products were demonstrably superior.  But what if substantial evidence suggests otherwise?  What if there are a number of clear and compelling reasons for a rational, self-interested investor to prefer an index product?  That brings us to what I believe is one of the fundamental questions in our industry today.  Where does one reasonably draw the line in regard to required disclosures regarding the risks and limitations for competing products and strategies where the relative efficacy of two or more alternatives is not obvious?

When giving presentations to ten or more members of the public, what if the following disclaimer was used:

The views expressed are those of (advisor name) and are not necessarily shared by (firm name).  Debate regarding market efficiency, the usefulness of fundamental and technical analysis, active vs. passive management and the efficiency of payments is ongoing.  To date, neither side has been able to claim unchallenged victory.

I cannot help but notice that people who favour active products and strategies, but fail to compare the two are not required to use the disclaimer.  The question that it begs is: “if neither side has been able to claim unchallenged victory, then how can an independent advisor recommend only one side to clients with a clear conscience”?  The corollary is: “how can it be acceptable to avoid an important disclaimer by simply avoiding a direct comparison”?  At the very least, shouldn’t all advisors be required to disclose that both alternatives exist, irrespective of the approach they favour- especially if there’s a reasonable possibility that the alternatives they favour is inferior to the one being recommended?  The industry hides the ugly truth by tolerating the non-disclosure of material considerations that could alter the decision-making process.

From my vantage point, the issue is not whether or not advisors should be allowed to advocate for one product line or business model or another.  Clearly, they can do whatever they feel is best.  The issue is whether or not they should be allowed to deliberately withhold credible and viable alternatives from their clients and still be considered independent professionals.

Thanks Jimbo. So what do you guys think? I realize this is written more towards advisors (as Jim’s articles usually are), but there is certainly food for thought for everyone.

Related posts:

1. Almost $250 Billion Invested in Closet Index Funds in Canada
2. Should MFDA advisors be allowed to sell ETFs?
3. Growing Active ETF Market Means Mutual Funds Should Consider Allowing F-Class Units For Sale Through Discount Brokerages

I made a 24 hour commando-mission to Atlanta last weekend and the result is that I will be co-authoring a new book which we hope to have published in May. I’ll fill you in on details as we near the end of the project, but I think I will have another book in me for 2010 or early 2011 as well which will be focused on sharing some horror stories with the hopes of helping figure out what NOT to do when it comes to managing personal finances – that was inspired by Larry MacDonald – who writes a blog here.

Mentions In The Media

Financial Post Magazine: 2010 RRSP Playbook

National Post: Investors have met ‘the enemy in the mirror’

Toronto Star: Requiem for a Bay Street Titan.

From Around The Blogosphere

Dan Bortolotti has recently launched an entire blog devoted to Couch Potato Portfolios. I see it quickly becoming a very popular website.

Rob Carrick talks about Post-Traumatic Stress Investing.

Jonathan Chevreau discusses a poll which found that 20% of people hope CPP and potentially winning the lottery will be enough to fund retirement. Yikes!

Ellen Roseman says it’s time to stop the madness.

Michael James elaborates on Ellen’s thoughts.

Canadian Capitalist links to an exposé on the Rich Dad, Poor Dad seminars. A must read.

Thicken My Wallet explains why the Latte Factor doesn’t work.

Million Dollar Journey shows us how one could save 70% off their grocery bill.

Four Pillars has an interesting post on bank accounts and dating.

Big Cajun Man wants a financial GPS.

This Week’s Racing Video

Rally drivers are bonkers. This short 22 second clip shows one driver jumping half a football field during an event. Holy moly guacamole!

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