In case the title of this page didn’t give it away, I’m not a fan of mutual funds. Let me explain by comparing VCN to a similar mutual fund from Investors Group, IGI832 (link: Investors Core Canadian Equity Fund A), If you walked into Investors Group and asked for Canadian equity I assume they’d give you this one. They might also recommend Investors Canadian Equity Fund which seems good until you find out it holds 25% US stocks. WHY DOES A FUND THAT SAYS CANADIAN EQUITY HOLD 25% US EQUITY? Ugh, it was surprisingly difficult to find a fund that had CANADIAN in the name but did not hold international equity. Even IGI832 only has 94% Canadian funds. Anyway lets compare:
|1 Year Return||24.34%||14.89%|
They aren’t identical, but they share 9/10 of the top holdings. Look at the difference in returns! The ETF beat the mutual fund by 9.45% this year! How did this happen?? They do hold slightly different stocks, but should that really account for a 9% difference? It could be three other things:
- Maybe the returns given on Investors Group’s website are out of date…….. checking google finance….. IGI832 returned 17.4% last year. That’s slightly better than their reported 14.89%.
- Mutual fund dividends are different in that they reduce the total share price but increase your number of shares, therefore you break even but google reports a lower return (since dividends on google aren’t reflected in the share price)…… checking Investors Group for distributions… 3% dividend yield. But wait, VCN has a 2% yield which is not incorporated into google’s chart either. Let’s just add the difference between the dividends. We get 18.4% for the mutual fund.
- Now lets add on the MER…..adding….. we get 21.4% expected return compared to the ETF’s 24.4%. Why did I add the MER? because the total fund will be reduced by exactly the MER when they take their fees for the year, unlike the much smaller MER on the ETF
How to account for the last 3% difference between the two funds? Maybe it’s because the mutual fund advisor was actively trading to enhance the return, but instead made things worse.
Lets check the funds over a longer time period with google. We will start when VCN was born in 2013:
Well that doesn’t seem so bad, with the 1% dividend difference the return would be roughly 3% less over the three years, or 1% per year for the mutual fund. But 1% per year is not zero, multiply that by your investing lifetime of 30 or 40 years and you’re looking to reduce your savings significantly. To make matters worse IGI832 has a Deferred Service Charge, which means that if you sell your shares anytime within the first SEVEN YEARS of acquiring them you’ll have to pay an EXTRA fee that ranges from 1%-5.5%.
Sure it seems that IGI832 is only marginally worse than VCN, but along with the lack of flexibility and lower return you’re potentially missing out on thousands had you chosen VCN.
Lets check a few more ETFs compared to their nearly equivalent mutual funds:
The USA is the worlds largest economy and you’d be right to include them in your portfolio. VFV is an ETF and the other two are mutual funds provided by Royal Bank and Investors Group. If you forgive the two drops in RBF, 10.79% and 22.28% (I’m not sure why google shows them), you get this comparison:
|FUND||TOTAL 3 YEAR RETURN||DIFFERENCE|
How is there such a difference between these three funds? How does the ETF return 15-20% more over three years not including dividends? There are two reasons:
- FEES – The mutual funds each charge over 2% in annual fees. That’s an immediate 2% loss PER YEAR compared to the ETF with a 0.08% annual fee.
- ACTIVE TRADING – The managers of these funds clearly are not performing well. They’re making poor trades that don’t justify their own fees. Remember they are trying to buy and sell within the fund to maximize returns. In order to justify their fees they should outperform the ETF by increasing the total return by the MER. Instead they are underperforming the ETF by 20%.
Have I convinced you yet? If you had invested $10,000 in each of these three you’d have roughly $15,000 with the ETF, and $13,000 with each mutual fund. Are you okay with throwing away $2000? Yes? Then keep reading.
“Hey the mutual fund in this example is doing better than the ETF! I’m going to disregard everything you said!” – The main point of mutual funds is to deliver returns that are higher than the index to justify the higher fees. This one is succeeding, but only in the past year has it really pulled away from the ETF. A few times in 2011 and 2013/2014 the mutual fund did better but the ETF always caught up, and there’s no reason to believe it won’t catch up again.
Before I concede defeat and start praising mutual funds lets check the underlying holdings in these two funds:
|XCH (ETF)||IGI565 (mutual fund)|
The mutual fund holds 5% more of the Tencent Holdings stock and 10% more Alibaba stock. That’s a big difference in holdings, if these two stocks performed well the mutual fund should have a noticeably higher return. Let’s check:
Wow! 42% and 67% gains! No wonder it outperformed the ETF! So yes, occasionally the mutual fund will perform better, but in this case it wasn’t because the fund manager made excellent trades, it was from the fund holding significantly more high performing stock.
Lastly, here are my three reasons to actually use mutual funds (yes I’m encouraging you to use them for these reasons):
- Niche Markets – Sometimes you can only invest in specific market sector via mutual funds (or buying the stocks directly) since no ETF is available for said niche. This might change as ETFs continue to grow in popularity.
- Partial shares – Mutual funds allow you to hold fractional shares as opposed to ETFs where they must be held in whole numbers. Thus if you invest with very little money (<$2000) and the share price is high (>$100) then owning a partial share will be a significant part of your investment, and the higher fees will be offset by higher investment gains from a higher investment.
- Your employer gives you no choice.
Lastly-lastly, some mutual fund providers (RBC for example) offer “passive mutual funds” which are basically index funds with higher fees (normally 0.75% to 1%). Use these if you can. They’ll likely accept partial shares too.
How I Justified Losing $900 to Switch to ETFs
The Deferred Sales Charge(DSC) is a fee that some mutual funds have to prevent you from prematurely selling out. The fee typically starts at 5.5% and drops every year eventually reaching zero after 7 years.
Mutual fund salespeople will talk unsuspecting clients into buying a fund with a DSC because many beginners(my former self included) don’t understand it. When I found out about DSCs I thought “there must be a good reason for it. It must give higher returns in the long run!” Nope. It’s purely for them to earn more money. They might say it’s a fee for financial advice they provide, but in reality the salesperson will make a higher commission if he sells you a DSC fund. And worse, sometimes they REQUIRE you to own DSC funds.
They may also claim the fee will encourage you to “buy and hold” but they are actually locking in a profit that way; either from the immediate DSC if you sell early, or from the MER over the 7 years it takes for the DSC to drop to zero. If there is a cash penalty to leave their company you won’t do it right? HAHA SUCKERS, I’m dumb enough to suck it up and pay the full 5.5%! Leaving Investors Group cost me around $900 because of these fees. “But Mr. Moose, why didn’t you just leave your money there until the fee drops to nothing?” Because I did the math:
Question: With a $10,000 investment in mutual funds, is it better to lose 5.5% to the DSC up front and reinvest in cheaper ETFs? Or leave the money in the mutual fund till the DSC drops to zero? The table uses the average return of each mutual fund and each ETF to calculate the net value after 7 years of returns. If the difference is positive, the mutual fund is a better choice.
RESULT: SELL MUTUAL FUNDS
If you own a US or Canadian equity mutual fund, it is absolutely in your favor to switch to an ETF. In this example the initial loss of $550 to exit the fund is hardly noticable compared to the $13,000 I would have gained over the 7 year timeline with the VFV ETF! Of course I’m still down $534 in the Chinese funds but it may just take a few more years for the ETF to catch up.
Have I convinced you not to use mutual funds yet? Now if you look really really hard you might find a few mutual funds that outperform their equivalent ETF, but typically 80% of mutual funds will under-perform. If you still insist on using mutual funds make sure you ask if they have an index fund with a lower MER.
Remember the only legitimate reasons to own mutual funds:
- Investing very small amounts (<$2000) – you can avoid some transaction fees and reinvest with partial shares
- Your employer restricts your group RSP account to mutual funds
- You aren’t willing to put a few hours into picking ETFs
- You aren’t willing to open a self directed investing account at a discount brokerage(If you can open a mutual fund account, you can open a self directed account)
There you have it! If you’ve read this page you now know more than the average mutual fund owner! Investing really isn’t scary and I believe in you! Sell your mutual fund and buy ETFs, your future self will thank you.
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