Submitted by Sara Worley & Brendan Donahue
Investment Advisors, Manulife Securities Incorporated
Most of the complaints about mutual funds centre on questions of performance, sophistication of fund managers and fees. Here we explore some common myths about those three issues.
Some people believe that, as a rule, mutual funds always underperform the index or more specifically, ETFs. While this is sometimes true, it is not always the case.
There are specific market environments in which ETFs and mutual funds outperform one another. For example, ETFs do well in periods where assets are appreciating quickly, such as during periods of market recovery. Perhaps the most famous example of this would be the financial crisis of 2008-2009.
While recovery periods can last a long time, it’s important to remember that the financial crisis and subsequent market correction were extreme and abnormal events. In normal markets, ETFs will always perform slightly worse than the index, while mutual funds at least have a chance to beat it.
As a matter of fact, some of the best money managers in the world are mutual fund managers, including Bill Gross, Peter Lynch and the Mawer team. Peter Lynch managed the Magellan fund for Fidelity Investments from 1977 to 1990, averaging a 29.2 per cent annual return. Bill Gross managed the PIMCO Total Return fund, and his success made it the world’s largest bond fund, with $270 billion in assets. And a $10,000 investment in Mawer’s New Canada fund back in 1988 would be worth over $546,000 today!
Some people avoid mutual funds because there is a fee associated with owning them, known as a Management Expense Ratio (MER). The costs included in an MER consist of the fund’s operating expenses such as trading, record keeping, audit and legal, compliance, reporting, fund valuation, taxes and management. For non-fee-based accounts, the MER also includes compensation paid to one’s financial advisor.
In truth, mutual fund MERs are comprised of the same expenses that a professional advisor and their firm would be responsible for to manage a similar portfolio of assets.
Those who want the expertise of a mutual fund manager but at a lower cost may consider using ETFs or individual stocks and bonds for moderately risky assets such as Canadian or US large-cap stocks, and mutual funds to buy complicated or exotic asset classes such as foreign stocks or global bonds. The key is to save money on simpler assets and make fees count by paying a professional to do what you can’t, or don’t have the expertise for.
Fees Don’t Matter
On the other end of the spectrum are those who believe that mutual fund fees don’t matter as long as the fund’s bottom-line performance is good. This is also untrue.
The importance of a fund’s MER depends on the type of fund. For example, conservative mutual funds that invest in Government of Canada bonds tend to be very similar, meaning there is a narrow spread between the best and worst performers. In this case, the MER can be important. Moving up the risk spectrum to balanced and stock funds, however, the relationship between fees and returns weakens.
Beware of closet index funds that charge full fare. If a fund is heavily correlated to a major index, it’s best to find another that isn’t, or save the fees and buy an ETF instead. If the mutual fund is invested in good assets and is uncorrelated major indexes, it would be difficult to replicate and is therefore offering value.
Final thoughtsThough mutual funds have gotten a bad rap in recent years due to market conditions which led to an over-performance of ETFs, they still address important asset selection, allocation and risk management aspects of a well-diversified portfolio.