Index vs Mutual Funds Investing

From everything I have read over the last ten years within the financial industry, high management fees (referred to as MERS) that mutual funds charge hurt the portfolios of small investors. If we in fact take a closer look at the Canadian industry, a majority of investors pay around 2% (and often more) for investing in mutual funds. So if you make an investment of $1,000 and the fund makes 5%, all you will earn is $30, with the other $20 going to your mutual fund company in order to pay the management fees (as well as the advisor who sells the fund). If you think about it, based on your investment return that’s a 40% commission.

But it gets even worse: just think if the fund that you invested in went down 5% in a bad market. Then you would show a $70 loss or -7%. No matter what, mutual fund companies are going to get their 2%. The rest will either go into your pocket or come out of it!

Unfortunately, for a very long time, mutual funds were just one way of diversifying into multiple products (bonds or company shares) that were professionally managed within a single trade. One mutual fund could be purchased by an investor, including part of it being invested into something safer such as bonds, as well as international, American and Canadian company shares. For those without a lot of investment knowledge, mutual funds do the job but they are also expensive.

The ETF Revolution

Like any other industry, whenever a product shows high profit margins or is overpriced, other players enter into the market and offer alternative options. Vanguard was probably the first to come up with an alternative option to mutual funds. It offered one of the first ETFs. Exchange traded funds (ETFs) are an alternative way of purchasing multiple stocks or bonds within one trade.

Simply put, an ETF refers to a group of various investment products (mainly bonds or company shares) that represents a basket. For instance, the ETF iShares S&P/TSX 60 (on the stock market it ix XIU), represents 60 of the largest companies trading on the Canadian market (TSX). An individual purchasing 1 unit of XIU is purchasing a basket that contains the 60 largest companies that are traded within the Canadian market. The ETF does everything for the investor, he doesn’t need to know anything about them or be able to mange them within his portfolio.

So what is the difference between purchasing the XIU and Canadian stock mutual fund? Around 2% in management fees. According to ishares.com, XIU fees are 0.18%, while a majority of Canadian stock mutual funds charge a management fee of more than 2%. What that means is that a portfolio manager managing a mutual fund needs to outperform the ETF by at least 2% before even $1 is generate for the investor. The following is a quick example to illustrate this:

$1000 Invested in Mutual Fund

Investment Fees: 2.18%
Investment Return: 5%
Net Return : 2.82% ($28.20)

$1000 invested in XIU

Invest Fees: 0.18%
Investment Return: 5%
Net Return: 4.82% ($48.20)

As can be seen, there is a large discrepancy between the ETF and mutual fund even if the same investment return is shown (before fees).

So Why Are Individuals Still Investing In Mutual Funds?

My answer is because it’s harder managing a portfolio than it is making a peanut butter sandwich!

Some people will then recommend a “coach potato” style of investing. This approach involves choosing a couple of ETF indexes that are a good reflection of your risk tolerance. Say you wanted to have a balanced portfolio (around 50% in bonds and 50% within the stock market. A portfolio could be built with just 4 ETFS:

10% in ETF that tracks International stocks
15% in ETF that tracks US stocks
25% in ETF that tracks Canadian stocks
50% in ETF that replicates the DEX (Canadian bonds overall)

I agree that just about anyone who has a pen, sheet of paper and calculator can build this kind of portfolio. You then rebalance your portfolio two times per year to ensure that you show the same percent always (buy low, sell high). That is a fairly effective method for managing your portfolio and tracking your return on investment in the markets (On a 5 year return, 95% of all portfolio managers fail to beat their benchmark). In addition, your management fee is less than 0.50%, which is 1.50% cheaper at least that it would be for the same investment that was part of a mutual fund. So, for example, if you were to invest $100k into this portfolio, you would save $1,500 a year in fees alone!

However, it isn’t that easy. It just isn’t that easy managing your portfolio.

When The Game Changes Here Is What Can Happen

Over the past year, a very low interest rate was being paid on bonds. This resulted in bonds starting to lower their value as interest rates started to rise. That’s why XBB (a Canadia ETF that tracks bonds) over the last 12 months has shown a -2.37% negative return. When the bond interest that this ETT pays is added (3.26%), the result is a small 0.89% investment return. What is the explanation of the fact that a majority of mutual funds performed better on their bond (fixed income) portion? After speaking with a friend of mine who is a great ETF investing fan, I noticed that over the last 3 years his bond performance wasn’t all that great. Poor returns on Canadian bonds mainly explained this.

I assumed at first that everyone had the same environment, until I was able to check the performance records of a couple of mutual funds. During that same period, a majority of mutual funds were showing better returns. How was that possible? It isn’t due to portfolio managers being better? It was due to the fact that they were including other classes within their fixed income portfolio like US bonds, international bonds and high yield bonds. That is why, mutual funds have been able to beat the coach potato classic portfolio over the last 3 years. It was due to the fact that other other kinds of investment classes were included.

Index vs Mutual Funds Investing

It’s true that if the same exact model had been replicated with 8 to 10 ETFs, then it probably could have beaten out the mutual fund. However, who is there to tell you that this type of portfolio could be made if you have adopted the coach potato style of investing? Your online broker isn’t going to. All he does is perform the trades. Your advisor won’t because you won’t have one.

You can probably see whee the problems lies with ETF investing: in order to build your portfolio and manage it, you do need to have a solid financial background. If you try doing it after just reading a couple of books, chances are good that you will have lower investment returns than the mutual fund even after the large fee that they charge.