UPDATE MAY 2018: The Investors Group fund that I use for comparison in this article has been merged with another fund – IG Franklin Bissett Canadian Equity Fund. Here is their reasoning:
These changes will improve our ability to ensure client portfolios are best aligned to address their unique needs
I’ve read that quote 5 times and still don’t understand how merging funds addresses “unique needs”. The truth is that mutual fund companies often discontinue (or merge) their funds when they aren’t performing well. This creates a survivor bias where all their funds appear to be doing great. But in reality many of their funds will be discontinued or merged in the future. Meanwhile your retirement is being eaten away by high fees and under-performing active management.
Investors Group also claims that they can reduce their fees by merging their funds. How much did they reduce them by? The new MER is 2.60%. That’s a reduction of 0.08% from the old MER of 2.68%. The new fee is now only 43 times as expensive as the ETF instead of 44 times. Hooray!
Read more here: HOW MUTUAL FUND PROVIDERS HIDE THEIR POOR PERFORMANCE
Also Google Finance is no more so the screenshots below no longer link to the customizable Google Finance sheets. Sorry.
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 the popular ETF by Vanguard – Canada All Cap Index (VCN) to a similar mutual fund from Investors Group, Investors Core Canadian Equity Fund A (IGI832). If you walked into Investors Group there’s a decent chance they’d sell you this mutual fund.
For this comparison we’ll look at the top 10 stocks held within the fund. The sector weighting, which is the industries where the holdings are concentrated, the Management Expense Ratio (MER), and a few other fun things. Here we go:
|1 Year Return||24.34%||14.89%|
The funds share 9/10 of the top holdings, although at slightly different percentages. They also share the same general sector weighting, being no more than 3% different in each category. The MER is vastly different with the mutual fund charging 2.62% more than the ETF.
Despite their similarities the 1 year returns are hugely different! 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- Maybe the returns given on Investors Group’s website are out of date……..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 according to google. That’s slightly better than the 14.89% they reported on their website.
- Mutual fund dividends reduce the total share price but increase your number of shares, therefore you break even but google reports a drop in value (since dividends on google aren’t reflected in the share price) and can artificially make the mutual fund performance look bad…… checking the Investors Group website… they report a 3% dividend yield. Meaning there was an extra 3% return that isn’t reflected on the google finance charts. But wait, VCN has a 2% yield which is not on google’s chart either. Let’s just add the difference between the dividends to the mutual fund’s return mentioned in point #1. So now we’re at 18.4%
- The MER artificially reduces the gains reported on the stock chart. Thus we can add it back in to more accurately reflect how the stocks performed……adding….. we get 21.4% expected return compared to the ETF’s 24.4%.
How to account for the last 3% difference between the two funds? Maybe it’s because the mutual fund advisor was actively trading in an attempt to get a higher 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 another Vanguard 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 consistently be outperforming the ETF . 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 on every $10,000 you invest?
“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.
The Only Reasons to Consider Mutual Funds
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 larger investment.
- Your employer gives you no choice.
- You are lazy and fine with 40% less money in retirement.
Lastly-lastly, some mutual fund providers (RBC for example) offer “passive mutual funds” or index funds. If you must use mutual funds for whatever reason, ask your provider if they offer index funds. They’ll have higher fees than ETFs(normally 0.75% to 1%) but you’ll get the benefits of partial shares and automatic investing and such.
How I Justified Losing $900 to Switch to ETFs
The Deferred Sales Charge(DSC) is an extra fee on some mutual funds. The fee typically starts at 5.5% and drops every year eventually reaching zero after 7 years. If you withdraw your investment from these funds you’ll be charged the fee on your entire investment. If you invested $10,000 in a fund with a DSC then decided to sell those investments next month you’d have to pay the 5.5%, or in this case $550. You’d get $9,450 back. Theoretically these funds have a lower MER and they use the DSC as an incentive for people to hold the fund longer (thus getting more profit from the MER which is still significantly higher than an equivalent ETF).
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. The slightly lower MER still doesn’t justify the investment. And in reality the salesperson will make a higher commission if they sell you a DSC fund. And worse, sometimes they REQUIRE you to own DSC funds.
From a business perspective the DSC is brilliant. That company profit is locked in as soon as the client invests. Either they earn money from the MER over time or from the DSC when they lose the client. If there’s a big penalty for leaving people are less like to do it right? WRONG. I did the math and paying the 5.5% and switching to ETFs STILL made more sense:
Question: With a $10,000 investment in mutual funds, is it better to pay the 5.5% DSC 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 compared in the article above to calculate the net value after 7 years of returns.
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 ETF!
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! Do your future bank account a favor. Sell your mutual funds and buy ETFs.
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