mutual fund

How to choose your manager

Our readers know our bias for an index approach; see Our philosophy . But we also recognize that in the present state of things the majority of small investors (institutions have long since learned to ignore mutual funds) choose actively managed mutual funds as their primary investment vehicle. Let’s look at the challenges you face when doing so.

There are over 5,000 mutual funds in Canada; source Morningstar. By comparison, the US, according to its current mutual fund industry association factbook (p.15), had about 9,000 funds at the beginning of 2009. Given the small size of Canada (ten times smaller by most measures) 5,000 is an incredible number for Canada. How does one pick out one fund?

The average investor chooses a mutual fund on the advice of a friend or family member or on the recommendation of his financial adviser, or more rarely, after doing his own research on sites such as Globefund  or Morningstar .
 
Friends or family are not necessarily the best sources. And the recommendations of your financial advisor should be taken with a grain of salt. Here's why.
 
Your financial advisor
 
Here are a few challeges in getting a recommendation from a financial adviser:

• Your advisor will tend not to recommend index products, because he believes, probably as hard as nails, that he can beat the market for his customers through a careful selection of securities or of funds, and this despite all the studies demonstrating the low chances of regularly beating the market in the long term. On this active predisposition of advisors, see Swedroe or as a PDF doc. 1550. It is true that any active manager can occasionally manage to beat the market, but that can be also be said of Lusha  the monkey; see Stewart or as a PDF doc.1551.
• Your advisor will tend to sell you in-house products houses. Nothing unusual there, since each one by happenstance has an employer who has a world monopoly on the best products.
• He will also tend to sell you the funds that have trailer fees, a quasi perpetual source of commissions that managers of most actively managed Canadian funds annually pay to financial advisers. The amount is calculated based on the number of fund units held by clients of the adviser. These commissions are the main reason why the costs of mutual funds in Canada are the most expensive in the world.

 
Management expense ratio (MER)
 
Here is the sad story as told by Morningstar:

An average Canadian equity fund purchased through an advisor with a front-end load might conservatively carry 3% to 4% in recurring annual fees after accounting for the fund's management-expense ratio (MER), trading costs, and any associated load. That takes a huge bite out of the long-term expected return on equities, which many experts peg somewhere in the high single digits.
A big part of the problem is that the rich trailer fees paid to advisors for as long as you hold the fund (0.5% to 1% annually for a typical equity fund) are bundled right into its MER whether an investor makes use of an advisor or not. And while there are lower-cost actively managed mutual funds out there, they typically require more substantial initial investments. An investor with less than $5,000 to invest who doesn't need the help of a financial planner is going to find it very difficult to avoid paying a trailer fee. Source: Morningstar or as  PDF doc.1552.

Think about it. In a average Canadian mutual fund, 4% of your investment disappears annually. By comparison the aggregate dividend yields of U.S. and Canadian markets are currently 2.7% and 1.95% respectively. At this rate, you miss completely the first 2% of annual capital gains on your investments, and if markets are flat, these costs eat up 2% of your capital annually.
 
In the U.S. it is estimated (see Swedroe or as a PDF doc.1552E and ETFdb  or as a PDF doc.1553) that society in general incurs U.S. $ 80 billion in unnecessary costs due to active management. We know of no specific equivalent estimate for Canada where the market is much smaller, but where management fees are also much higher, but Robert Pouliot doc.1559 estimated in 2007 that mutual fund fees in Canada were between 23 and 46 billion dollars higher then they should be in Canada. What we also do know is that the Canadian mutual fund industry estimates the number of direct and related jobs at 90,000, a staggering number for a country of thirty million people:
 
The mutual fund industry currently employs more than 90.000 Canadians, both directly through fund management companies and fund dealers, and indirectly through operational staff, researchers and administrators. Source: IFIC or as a PDF doc.1554.