Gotcha!

Many writers and experts have commented on the proliferation of bad ETFs as manufacturers cash in on the caché of the ETF name. We’ve seen leveraged ETFs, niche sector ETFs, and alternative strategy ETFs pop up and uninformed investors flock to them still. (For the record, I don’t have anything against leveraged ETFs or sector ETFs and the sort, I take issue with uneducated investors/advisors not knowing how to use/sell them properly).

I attended a press conference yesterday on a new company launching some pretty wild ETNs, and ironically I ran into the author of the Canadian Couch Potato blog, Dan Bortolotti. It’s ironic because the couch potato portfolios stress using the most simple, low-cost, broad ETFs and well, keep reading…

If there is an exotic investment strategy out there, there will soon be an ETF conjured up to make it accessible for the masses. Witness the latest offering from a new company out of California which had previously offered turn-key derivative strategies to pension consultants but have now decided to make these strategies available to retail investors through the use of ETNs (exchange traded NOTES as opposed to FUNDs – which means the investments are senior debt issues of the company, the investor only owns a promise from the company to pay out).

This particular strategy, actually a pair of strategies, are essentially straddle strategies. Think of buying a put and a call on the same stock while waiting for a news release. After the announcement, the stock might shoot up or down and either the put or the call will be worth a lot and the other expires worthless. These ETNs are somewhat similar to this…

One ETN will give you a return of +2.5% after fees for one month if the underlying index (the S&P 500) does not increase or decrease more than 5% from the index price at the beginning of the month. Essentially, you will make 2.5% for the month if the market is relatively “flat”, and as such the ticker on this ETN is FLAT. If the index increases/decreases by more than 5% (at any time during the month) then you earn nothing and you get your money back, less the MER.

The other ETN will give you a return of +5% after fees for one month if the underlying index (again, the S&P 500) DOES increase or decrease by more than 5% at any time during the month. In this case, you can earn 5% for the month if the market is “volatile”, and as such this ETN ticker is FAT. If the index doesn’t increase/decrease by 5% then you earn nothing with FAT and you get your money back, less the MER.

Each ETN essentially resets at the end of the month. The MERs for FLAT and FAT are 2.5% and 3.0%, respectively…. PER MONTH. But here is the kicker: creation units will only be issued if there are relatively equal amounts of FAT and FLAT being bought. Why is this important? Because the market will either increase/decrease by more than 5% or not, and in each case the fund company has one winning hand and one losing hand. (I’m relating it to gambling for a reason!)

In either case, the fund company is essentially guaranteed to make a killing. Since the fee on FLAT is 2.5% per month and if you “win” you get 2.5% – they lose no money, but they make 3.0% on FAT – so they are net ahead 3.0%/month when the market is not too volatile.

When the market IS volatile, they pay out 5% since they “lose” on FAT but collect a 3% fee for the month on FAT. This puts them behind 2% BUT also are ahead by 2.5% on FLAT because those investors would have “lost” – meaning they are again ahead by a net of 0.5%/month.

If you think you can time volatility, be my guest and use these. Personally I would rather buy the stock of the company instead. But for those who need a little active management but still want to stick with plain indexing, Dan is actually in the midst of setting up a couch potato portfolio advisory service with an option of some *slight* market timing with the portfolio allocations, but I think he may use some of these ETNs as hedges for his market calls! Sounds interesting, although I think it is tainting the nature of the couch potato philosophy… Check out Dan’s blog for more details, and I would be interested in your comments.

Related posts:

1. ETNs – Exchange Traded Notes
2. Some Investors Currently Using An Advisor Could Probably Be DIY Investors
3. CanadianCouchPotato.com

Bond desks can either be run as profit centres or not. When I was at ScotiaMcLeod and I wanted to buy a bond for a client, I would call up the bond desk downtown and get the price for what was in inventory and it was nice to know that our bond desk was NOT run as a profit centre. Ultimately it means the client gets a better price and therefore a better return on their money.

Some bond desks, however, are run as profit centres which means that the bond traders have to take their cut and management expects them to generate revenue for the firm as well as providing inventory to the salesforce (the advisors buying and selling bonds for clients). This revenue ultimately comes out of the end investor’s pocket.

An investor who uses a brokerage whose bond desk is run as a profit centre might get a bond at 95 whereas that identical bond sold through a brokerage whose bond desk is not run as a profit centre would get that bond at a price less than 95. This is independent of the commission paid to the advisor which is a separate consideration.

I’m going to guess that this is not a question that many people think to ask a potential new advisor, but I think it is an important one.

Related posts:

1. Growing Active ETF Market Means Mutual Funds Should Consider Allowing F-Class Units For Sale Through Discount Brokerages
2. When Interest Rates Go Up Bond Prices Fall
3. What is a Bond? Part 1

Today’s post title would be the logical reaction to the “threat” of actively managed ETFs. By allowing the widespread sale of F-class units of mutual funds through discount brokerage accounts the fund industry could help stem any potential losses.

F-Class Mutual Fund Units

For those not familiar with F-class mutual fund units, they were developed for Fee-based accounts where advisors would charge a transparent fee which was not embedded in the fund’s MER.

For example, let’s say that Mutual Fund ABC had A class units with a 2.50% MER, of which 1.00% went to the advisor annually as their compensation. The investor would not explicitly see the portion of the fee going to the advisor (1.00%), nor would they see the 1.50% going to the fund company for the portfolio management, reporting, etc. If the return for the year was 10.00%, the portfolio’s actual return would’ve been 12.50%, but the 2.50% would reduce that to the 10% the investor sees.

Now, that same mutual fund could be offered in a F class unit (same portfolio) which has an MER of 1.50%. The advisor might charge a “client advisory fee” of 1.00%. The total cost is still 2.50% but in this case the 12.50% portfolio return is only reduced by 1.50% so the investor sees a portfolio return of 11.00% BUT they also see 1.00% in fees deducted explicitly on their statement which goes to the advisor, leaving them with the same 10.00% net portfolio return.

It should be pointed out that the 1.00% client advisory fee is potentially tax deductible for non-registered accounts, which would leave the investor slightly ahead versus the A class units with the same overall fees.

So what’s the big deal? Well, for one that Client Advisory Fee is negotiable, but that’s beside the point. Right now, you can buy A-class units of actively managed mutual funds through a discount brokerage and bypass the use of an advisor, but you still pay the 1.00% that would go to an advisor. Essentially, you are paying more than you have to. Many fund companies have blocked the sale of F-class units through discount brokerage accounts in order to appease financial advisors who would be threatened by this practice. Presumably, when bought through a discount brokerage account, an F-class unit would be absent any advisor compensation and in our sample mutual fund, the investor would pay an MER of 1.50% versus 2.50%. (These MERs are just examples, they could be higher or lower.)

Hop On or Get Out Of The Way

So… if the proliferation of Actively Managed ETFs accelerates (which it has) then DIY investors will be more inclined to circumnavigate financial advisors in order to access active management without the advisor compensation drag on portfolio returns. If the fund companies are unwilling to realize that there will be an exodus then they stand to lose market share going forward.

Let me be clear with my own perspective: there is value in advice and I believe that most people will be better off with an advisor. But, the truth is that there is a significant portion of the investing public who wish to do it themselves and that demographic will increase.

Witness the FSA in the UK moving to ban commissions for financial advisors, and similar directives in Australia for CFPs. The advice delivery mechanism is changing to an unbundled structure (advice not tied to products), so making F-class units available through discount brokerages is only logical for fund companies from a business perspective.

It wouldn’t signal the end of financial advisors as some might fear. I believe there is an equilibrium (like with pretty much everything) which would shift from 10% DIY / 90% Advice to perhaps 30% DIY / 70% Advice whether the fund companies do this or not. If they do it though, they should be better off.

Comments welcome.

Related posts:

1. Point of Sale Disclosure for Mutual Funds
2. Point Of Sale Disclosure For Mutual Funds Miss The Mark
3. Mutual Funds: Great for portfolios up to $100,000

So once you have built your portfolio past $100,000 it is time to compare costs of paying a mutual fund manager versus the costs of having a stockbroker build a custom portfolio (or yourself with a discount brokerage trading account if you have the knowledge).

Let’s look at the average Equity Mutual Fund. It has an MER (Management Expense Ratio) of approximately 2.6%. That means that for every $100,000 in your portfolio, you are paying $2,600 per year for management. When you were starting out your savings, perhaps you had $5,000 in the fund at the end of your first year – you were only paying $130 in fees. In fact, that is quite a bargain considering your advisor probably spent much time meeting with you, learning about your situation and creating a plan and investment recommendations. He or she does this so that when you become a larger investor, you become a larger source of income for the advisor. Also, by having built a relationship over time, it becomes a strong bond and there is less likely a chance that another advisor will lure you away (all thing being equal).

But let’s say you stay in this fund and now your portfolio has reached $1 million. You still pay 2.6%, and in this case you are now paying $26,000 in fees for the same management. It starts to get depressing if you consider that $26,000 every year could buy a new mid-size family car!

So let’s look at two options:

1. Fee based advisor

A fee-based advisor works on a set percentage of assets – think of it as similar to an MER, except that in the industry it is called a “Client Advisory Fee”. You don’t pay a trading commission for each stock purchase setting up the portfolio and similarly you can sell those stocks and buy new ones without incurring a separate commission. The Client Advisory Fee pays for all your trading costs, account admin fees, everything. Even if the Client Advisory Fee was the same as the MER (2.6%), it is advantageous because this fee can be written off for tax purposes whereas an MER cannot (for non-registered investment accounts only, you cannot write off fees for an RRSP). For easy math’s sake, let’s assume that our client is in a 50% Marginal Tax Rate. If they could write off the 2.6% Client Advisory Fee, then it effectively becomes reduced to 1.3%. That is a huge saving right off the bat.

But, it only gets better. While Client Advisory Fees usually can only be offered for $100,000+ sized accounts, this fee can be reduced automatically as the portfolio grows even larger. For example, the fee might be 2.5% up to $249,999 but once you reach $250,000 the fee might drop to 2.25% (and that would apply to the whole account, not just the funds over the threshold). Every advisor and firm have their own set of thresholds and fees – but know that you can negotiate the fee. As accounts grow to $1 million you should easily be able to negotiate the fee down to 1.25% (which, for a non-registered account could be written off and effectively reduce the fee to 0.625%) . When you set up your fee-based account, you will sign a document that clearly outlines the thresholds and fees for each level.

2. Transactional Advisor

In this case you pay a commission for each transaction – i.e. to buy or sell an individual stock. While it would take you maybe 20 purchases to setup the portfolio initially, and just for argument’s sake let’s say each transaction cost you 3% of the purchase price, then your first year would cost you roughly 3% in fees. BUT, once you’ve setup the portfolio most of the work is done, and the rest is maintenance. For example, you made 20 transactions in the first year, but in the second year you only made 6 transactions because it was time to sell 3 stocks, and you needed the other transactions to buy replacement stocks. So perhaps in the second year your total fees were only 0.9%. It all depends on how many trades you make in the year. (If you are an active trader, endlessly trading stocks then you already know you should be on a discount trading platform designed for active traders. )

It is important to note that you can replicate the characteristics of the mutual fund you’ve left with individual securities. But it might be more important to note that you can modify it now according to your personal preferences as well as paying a lower amount of fees every year.

I recently moved a client from another institution to my care. He had a portfolio of $180,000 entirely in mutual funds with an MER of 3.03%. We setup a fee-based account with a client advisory fee of 1.5% up to $1 million, and it would reduce to 1.25% over $1 million when he gets there. It was a non-registered account so he can also write off the Client Advisory Fee. Let’s do the math:

Before:

$180,000 x 3.03% MER = $5,454 yearly cost

After:

$180,000 x 1.50% Client Advisory Fee x 50% Write off of fee = $1,350 yearly cost

This client will save roughly $60,000 in fees over a ten year period. This will be due to the fact that the portfolio will appreciate over time and the yearly savings will also increase.

This is another “no-brainer” investment decision quite frankly. If you have over $100,000 in your investment portfolio, it’s time to speak to your advisor about fees. They would rather lower their income and keep you as a client then lose you and get NO income… And of course if your advisor can only sell mutual funds, it may be time to look for a full service broker who is authorized to sell everything (mutual funds, stocks, bonds, etc.).

Related posts:

1. Growing Active ETF Market Means Mutual Funds Should Consider Allowing F-Class Units For Sale Through Discount Brokerages
2. How Mutual Fund Sales Are Compensated In Canada
3. Tax Advantages of Segregated Funds versus Mutual Funds

I suppose this should be one of the first posts seeing as how most people are invested in mutual funds (and have no idea what they are, what the differences are between them, and what kinds of mutual funds there are out there). It is also of note that many investors might be better off getting out of mutual funds at a certain point… but I’ll get into that in another post!

A mutual fund is a means for small investors to pool their money together (MUTUALLY) with other small investors so that they may hire a Mutual Fund Manager to take the collective funds and create a diversified investment portfolio that is invested on behalf of all the small investors. If Investor A has $1000 of his/her money in the mutual fund and Investor B has $10,000 of his/her money in the mutual fund and the Mutual Fund Manager has guided the portfolio to a 10% return, then Investor A now has an $1,100 stake in the fund and Investor B as an $11,000 stake in the fund.

So you might be wondering who the charitable soul is who has decided to manage this investment portfolio on all these investors’ behalf? Well, don’t you worry! He/She gets paid, and paid well! One of the most oft reported pieces of information on mutual funds in the media is what is known as the MER of the fund.  MER stands for Management Expense Ratio and is in essence how much money is paid to the Mutual Fund manufacturer in order to cover all costs of running the fund.  This includes the pay for the mutual fund manager, his/her research team, support staff, the paper your statements are printed on, the lights and phones in the office, not to mention paying the mortgage on the building and property, advertising the fund, etc. Oh, yeah it also includes the commission your financial advisor may earn for selling the fund to you and maintaining a relationship with you.

The MER is deducted before all performance reporting. So in the example above, if the MER of the mutual fund was 2%, then the mutual fund manager was actually able to generate a 12% return.  Once the 2% MER was deducted, we are left with 10%.

Most people are quite content to pay 2% (and not really noticing it because it doesn’t show up anywhere on their statements) (Then again, most people don’t even know that they are paying it!).  Once you actually break it down for people (and when you are dealing with larger and larger investment portfolios) then they start to pay more attention. For example if someone with a $1 million dollar portfolio is paying a 2.5% MER and there is a similar fund out there with a 1.5% MER, that’s $10,000 being left on the table every year. If we apply the same thought process like we did with the savings account question, multiply that amount by a couple of years and the foregone growth and it quickly become a matter of hundreds of thousands of dollars if not millions!

But of course, we have to look at why people would want to use a mutual fund in the first place. Well if you have $1000 dollars to invest, you are not going to get a very diversified portfolio if you try to buy a bunch of stocks individually. The commissions per transaction would eat up a sizeable chunk of your $1000 right off the bat.  You may need to earn a 30% return just to break even!  And if you could do that with confidence I’d be wondering just how it came to be that you only have $1000 to your name!  That is why I kept using the words “small investor” in the beginning of this post. Once you have a larger portfolio (generally speaking, nearing $100,000) you CAN start to create a diversified portfolio without brokerage costs killing you.

The other point to mention is that some people use mutual funds because they want a dedicated team of experts handling their hard earned cash. Remember a mutual fund manager and his/her team works almost ’round the clock and they are immersed in the world of investing and have studied long and hard to get where they are.  So a lot of people who don’t have the time, knowledge or desire to handle their investments will hire a professional to do it for them.

Okay, I think that is probably enough of a primer on mutual funds to get started with.  Let’s let that sink in before getting back into it… because there is a lot more to it, that’s for sure!

Related posts:

1. Mutual Funds: Great for portfolios up to $100,000
2. Mutual Fund Corporations versus Mutual Fund Trusts
3. Growing Active ETF Market Means Mutual Funds Should Consider Allowing F-Class Units For Sale Through Discount Brokerages

If you’ve read the “How to use this site” section you will have noticed that there are going to be various levels of information presented here with respect to knowledge levels. But since that in itself is quite vague, I though I would write a post describing some of the things I will be talking about (In addition to what you guys ask about!).

In addition to defining some of the terms I think everyone should know, I’d like to explore how many different types of financial advisors there are out there and specifically how each operate and are paid. There is a HUGE spectrum. And the right fit for one person might not be the right fit for another!

Also, I’m going to demystify leveraging (borrowing to invest). (p.s. your mortgage is a leveraged investment!), and why it is so popular and also very scary. But I’m also going to talk about creating monthly budgets, how to save money in the first place (you have to be a saver first before you can be an investor!), the various different avenues to getting a mortgage, how to save money on buying/leasing a car – you name it, the sky is the limit!

I also hope to have people contributing information as well as I don’t have the answer for everything – similar to my job, I rely on a team of experts to know the nitty-gritty details of specific subject matter – I’m just a liaison between the super-smart bean counters and my clients!

In any case, I’m going to jump from topic to topic and follow up with the discussions when they are generated. I will archive the posts into the specific categories as time goes on so people can sift through (hopefully) an ever-growing repository of information.

Remember – if you have any questions: please post them in a comment or you can email me at preet.banerjee@gmail.com and I’ll create a posting on it for you!

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