Would the Real “Fund” Please Stand Up!

high_riskDuring this two-part series, I examine some of the basic funds and ETFs available, and why most investors would be better off sticking with index funds and index ETFs. Part-1 is a basic definition of mutual funds, index funds, and ETFs. In Part-2, I cover the different types of ETFs in more detail. I also cover the associated risks with many of the actively-managed ETFs on the market.

Part-1: Mutual Funds, Index Funds, and ETFs

Confused about the differences between mutual funds, index funds, and all the ETFs (Exchange Traded Funds) available to invest in? Well you’re not alone.  According to the Investment Funds Institute of Canada, at the end of May 2011 there were some 2,157 mutual funds listed in Canada, with $66.7 billion in assets. There were also some 184 ETFs listed on Canadian exchanges, worth over $41.9 billion dollars. This represents a combined total of over $108 billion dollars invested in both mutual funds and ETFs in Canada.

Canadian ETFs

Since the launch of RBC’s new target-date-bond ETFs last week, the total number of ETFs in Canada is probably now closer to 200. On top of that there are a bewildering difference of investment strategies and types of funds and ETFs available for investors. While ETF sales have soared in Canada since 2007, that’s not to say investors have had a better choice of products to choose from. Unfortunately many of these products are simply unsuitable and unnecessary for the average investor.  On the flip-side there are also many more indexed products available, though some of these ETFs also use swaps and covered-call strategies. Confused? Who wouldn’t be?  Let’s clear up some of these confusions and get back to basics!

 WTF (What the Fund)?

Everything seems to be called a fund these days! The word “funds” can be quite misleading, and that is where people get confused:  Mutual Funds, Index Funds, and ETFs (Exchange Traded Funds) are all different animals. And even within the ETF umbrella, the diversification of strategies and types is staggering. Danielle Arbuckle at Financial Highway covered some these points briefly in a recent post about investing in Exchange Traded Funds. Dan Bortolotti regularly scrutinizes new ETF products in detail, at the Canadian Couch Potato.

Here are the basics on “funds” from the Dividend Ninja perspective:

Mutual Funds

Most people have a basic understanding of what Mutual Funds are, since they have invested in them at some point in their retirement plan.  A mutual fund is basically a pool of funds collected from many investors for the purpose of investing in securities such as stocks and bonds. Most mutual funds are actively managed, in other words an investment manager decides on the securities to purchase, and manages the portfolio. In addition Mutual Funds rely on print and advertising media which also adds onto their costs. This results in a higher MER (Management Expense Ratio).  According to a recent article by Rob Carrick, The average Canadian equity mutual fund has an annual MER of 2.43%, which is in addition to any trailer fees or commissions.

Mutual funds have also been under heavy criticism for many years, since they are often sold with commissions, as well as trailer fees (kick-backs to brokers for selling them). While most mutual funds allow the small investor to get started, most underperform the very benchmarks they are compared to, in combination with high fees.  While mutual funds are a win for the companies who manage them and the brokers who sell them, most investors are paying a premium for underperformance.  This is something I have been doing the research on lately, for yet another blog post. I was quite surprised to find by how many percentage points, the top performing mutual funds are lagging the index.

Index Mutual Funds (Index Funds)

Index Funds are also a type of mutual fund. But that is where the similarity ends!  Index Funds are not actively managed, but simply invest in a basket of securities that matches an index (i.e. the S&P 500 or the TSX Composite). Therefore the investment style is referred to as passive management or passive index investing. In other words the entire performance of an index fund is tied to the market, and not the performance (or underperformance) of a mutual fund manager.

For example a Canadian Index Fund such as, TD Canadian Index Fund e-series, would track the S&P/TSX Composite Index. If you don’t understand what that means, think of it this way: The TD Canadian Index Funds simply buys all the stocks that comprise the S&P/TSX Composite index (currently 260), which are the majority of Canada’s biggest companies. You then buy a share of the TD Index Fund, and become a part owner of all of those stocks without having to buy all the companies yourself.

Index Funds are usually bought through banks without commissions. Since brokers and mutual funds dealers don’t make money selling them, or are able to sell them, almost all index funds have no trailer fees. Index funds are not usually promoted in print or media advertising, so all these administration costs are saved through a much lower MER. In fact, the MER for the TD Canadian Index e-series Fund is only 0.32% – compared to the Canadian equity mutual fund average of 2.43% (mentioned above).

So the two key differences between Index Funds and Mutual Funds are: (1) Mutual funds are actively managed with high fees, and (2) Index Funds are passively managed with low fees.

Note: Be careful with mutual funds that masquerade as “index funds”. These mutual funds still have the high MER, the trailer fees, and associated commissions. There is no evidence to suggest that no-load mutual funds or low MER mutual funds have better performance, than their higher-fee counterparts. Stick with true index funds!

ETFs (Exchange Traded Funds)

Similar to mutual funds, an Exchange Traded Fund (ETF) is a security that tracks an index, a commodity or a basket of assets like an index fund (or a sector mutual fund), but trades like a stock on an exchange. By owning an ETF, you get the diversification of a mutual fund as well as the ability to sell short, buy on margin and purchase like a stock. Unlike mutual funds however, ETFs have very low MERs, and no trailer fees. Although you must pay the regular brokerage fee to buy and sell ETFs, you gain the benefit of low operating expenses and therefore a lower MER.  ETFs are suited for the investor with a large portfolio, who can purchase enough shares to be able to DRIP (Dividend Reinvestment Plan) their shares, and make the fees to purchase negligible.

ETFs can be either passively managed or actively managed. Most ETFs hold the underlying securities they are tracking. However many ETFs, have strayed from their passive roots and become inverse, hedged, swaps, or covered-call ETFs. I’ll cover more of this confusion in Part-2.

Index ETFs

Index ETFs are much like index mutual funds.  As explained by Investopedia, these ETFs follow a specific benchmark index as closely as possible, but use a passive investment strategy, only making portfolio changes when changes occur in the underlying index. The benefit of and Index ETF over an Index Fund, is of course the much lower MER (Management Expense Ratio). In the Globe and Mail article mentioned above, Rob Carrick compares iShares XIU-T, the most popular ETF in Canada which tracks the S&P TSX-60 Index. It has an MER of only 0.17%. Index ETFs offer you true index investing at a low cost, with more options available than only holding index funds. However they are suitable for investors with larger portfolios, who can absorb the transaction or rebalancing costs.

Note: Horizons BetaPro HXT and BetaPro HXS are being heavily promoted and advertised as low-cost index ETFs across various media. They have an incredibly low MER of only 0.07%. However employ caution! These ETFs do not hold the securities they invest in (for the most part), and use a swap agreement to guarantee the index returns. Since they do not hold the securities they invest in, for this reason alone, I do not consider these true index products. Back in October 2010, I wrote about the issue with Horizons HXT, and why I feel it’s a poor choice for investors.

Conclusion

In Part-2, I cover the different types of ETFs in more detail, and some of the associated risks with the newer ETFs on the market. These are namely the actively managed ETFs that employ: covered-call strategies, swaps, forward agreements, inverse or hedged options strategies. Although they may give you a higher return so comes the higher risk. I’ll also explain why I feel the majority of these ETFs are not suitable investments for the majority of investors.

Stick with true Index ETFs and Index Funds that do hold the securities they are tracking, and use passive investment strategies. As the Canadian Couch Potato would say – “stay passive my friends.”
The Dividend Ninja – Jul 12th, 2011

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