Growing Active ETF Market Means Mutual Funds Should Consider Allowing F-Class Units For Sale Through Discount Brokerages

Posted by Preet on Mar 23, 2010 | 3 comments

This past Monday I had a guest post about how Actively Managed ETFs will signal a threat to the staying power of mutual funds as portfolio stalwarts. In the face of mountains of evidence supporting indexation strategies, actively managed mutual funds with embedded financial advisor compensation have flourished. The author essentially argues that the mutual fund structure is being challenged as now investors can access active managers while bypassing the financial advisor as an intermediary. For more, please make sure to read the guest post here.

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.

Leverage Part 2: The Dark Side!

Posted by Preet on Aug 1, 2007 | 0 comments

So now that you are all hot and bothered about getting an investment loan (aka leverage), let me take you down a notch! (Trust me, it’s for your own good…) :)

Okay, so let’s now say that Greg, who if you remember had learned that he would be $2,000 ahead by getting a loan, decides to calculate a few “what-if” scenarios…

1. What if the investment only earns 6%?

In this case, the investment’s rate of return and the interest on the loan are equal. How much does Greg have at the end of 10 years? In this case the leverage will leave him with just $13,487 at the end of the 10 years. If he had made the annual savings of $1,000 into a 6% investment – he would have $13,972 – almost $500 more.  So in this case the leverage would’ve been the wrong decision.

2. What if the investment makes no money after 10 years?

Depressing, but a lot of investors guide themselves to a 0% rate of return by switching their investments around too much – always a step behind “the next hot pick” (but that’s another story!). Okay, in this case the “straight savings” (putting $1,000 per year) will give you, yep you guessed it $10,000! The leverage? Another no brainer – Greg’s loan for $7,531 doesn’t grow and that’s all he has at the end of 10 years. I think you can see that we’re getting further and further behind with the leverage…

3. What if the investment loses 10%?

We looked at a gain of 10% in Part 1, so let’s look at a loss of 10%.  It would take real skill to lose 10% per year over 10 years – but I suppose it could happen if someone were really clueless… The straight savings will leave Greg with $5,862. Yikes! But if that wasn’t bad enough, the leverage would leave him with $2,626!!!

I think I have built a solid case for why you may want to think twice about leveraging.  But there is SO MUCH MORE TO THIS STORY than just the examples I have given. From here on in it’s going to get even wilder (both in terms of potential and volatility).  Near the end of the series on leverages, once I have shown enough case studies to educate you to the level of an average financial advisor (on THIS topic), I will show you some advanced leverage strategies that I use with my clients on a regular basis – but it is much more complex than the stuff we’ve just talked about – because I am not a fan of risk – and neither are my clients!

Can you Diversify too much?

Posted by Preet on Jul 31, 2007 | 0 comments

This is a tricky topic to talk about.  So please read the caveat at the bottom of this post!

The wealthiest people in the world have, on average, made their fortunes on ONE stock… and that is usually the stock of the company they themselves founded and ran in the form of a small business that just kept expanding.  But of course for every small business that becomes the next GOOGLE, there are countless more that fail and go under. This is the ultimate example of why you won’t get rich quickly by diversifying AND how you could lose everything quickly by NOT diversifying.

Understanding this debate is understanding the trade off that you want to make between risk and reward. You take on an astronomical amount of risk by buying only one company’s stock, but if that company is indeed the next GOOGLE well then it was worth it, wasn’t it? :)

Similarly, a lot of successful investors advocate buying only a handful of stocks (maybe 10-20) that they KNOW and BELIEVE in and expect will grow faster than the rest of the economies in which they are domiciled.  They understand it will be a rockier ride than holding every stock in the world, but expect to be rewarded over the long term for the increased amount of risk they expose themselves to.

By properly diversifying, you virtually guarantee you will never get rich overnight, but you also virtually guarantee you won’t lose your shirt either. Conversely, by under-diversifying you open up the possibility of making a lot money very fast… or losing it!

For new investors – you will want to diversify as much as possible, and across multiple levels of diversification as well – see “What is Diversification?”. (At least until you get your feet wet and experience a full market cycle.)

Picking investments based on past performance

Posted by Preet on Jul 29, 2007 | 0 comments

Invariably people will see a ranking of highest performance funds for the last year or so and ask “Are these good funds?” Others will just go and blindly buy them. In fact, there is a huge proportion of investors out there who base most of their decision on the past performance of an investment alone.  They do not research any further than the performance report for the last year.  This is no different than gambling in my eyes!

To paraphrase a quote I once heard, if all that was involved in achieving the highest rate of return was looking at past performance – librarians would be the richest people on earth! Last time I checked, they were not (at least on average).

In fact there have been numerous studies that have looked at mutual fund rankings year over year.  What they all find is that the #1 performing mutual fund over the last year will be very close to the worst performing fund the next year. These studies are numerous and they all have the same results.  In fact, the worst performing funds also have a tendency to shoot up the rankings the following year.

So what does this tell us?: That you cannot blindly look in the newspaper and look for last year’s best performing fund and expect it to give you the same performance every year.  In fact, if you take nothing else away from this post take this: Next time you see a mutual fund returning over 50% in the last year, take a look at it’s 5 and 10 year averages.  If the longer term averages are, say closer to 10%, then doesn’t it stand to reason that to revert to the mean will require some dismal performance in the future?

What I’m really trying to advocate is that you should take some time to get advice and do some research on what you are buying.  I’m convinced that people take more time choosing between fridges for their house than they do their long term investment selections! I realize that a lot of people are quite intimidated by the task, but do your due diligence! Again at the very least, if you are still going to go out and buy yester year’s hot performer – ask for a professional’s two cents on the fund first! Even the fund company who sells the fund will tell you not to expect the performance to continue forever!

What is a Mutual Fund? A basic understanding…

Posted by Preet on Jul 26, 2007 | 0 comments

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!