Why Canadians Should Avoid Mutual Funds

This article was originally published on The Dividend Pig, as part of the Financial Literacy Day campaign, in Why You Should Avoid Mutual Funds.

According to Andrew Hallam, from Millionaire Teacher, Canadians are in the last spot at 18 out of 18, paying the highest mutual fund fees in the entire world! (Millionaire Teacher, pg.54)

Back in November, as part of the Financial Literacy Day campaign, I wrote about why you should start investing now. My point was to show how easily a nominal $25 per week invested, can grow into a sizable portfolio of over $17,168 in only ten years. For that figure I assumed a very conservative annual total return of only 5%!

I also showed how Canadian investors can take advantage of four TD e-Series Index Funds to build a portfolio for only $100 per month, with a purchase of a fund each week at $25. I also showed readers why the TD e-Series funds are such a great deal! There are no commissions to purchase or sell, and the MER (Management Expense Ratio) is less than 0.33%. Unfortunately, these funds are not well known to most Canadians. It’s a different story for Canadian investors who purchase actively managed mutual funds, and who are paying a premium in fees and being rewarded with under-performance.

What the Fund?

Bad day in the market with mutual fundsBack in July 2011, I chopped through all the complexities of mutual funds, index funds, and ETFs (Exchange Traded Funds) in Would The Real “Fund” Please Stand Up!If you aren’t up on the terminology, nor understand the difference between index funds, ETFs, or mutual funds, then be sure to check out this post. It’s a back to basics post for any investor.

Most people have a basic understanding of what Mutual Funds are, since they have invested in them at some point.  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.

Most people start off with mutual funds, because it was what they know best through advertising, or by talking with their bank rep or directly through a mutual fund dealer. Mutual funds have long claimed to provide investors with professional management, above market performance, and a solid long-term investment strategy. Yet actively-managed mutual funds rarely deliver on any of these promises, and cost investors a small fortune in ongoing fees.

The main three reasons are:

  • Upfront Fees: Commissions to Buy and Sell
  • Hidden Fees: MER with included Trailer Fees
  • Under-Performance

1. Upfront Fees

First, mutual funds are expensive in terms of the fees and commissions they charge upfront. What most people don’t realize is that many financial advisors are not financial planners, they are mutual fund dealers. Many mutual fund dealers charge hefty front-end and back-end commissions. These are usually laid out as front-end, back-end, and deferred-sales-charges depending on the length of time the funds are held. Here in Canada, these fees can vary anywhere from 2% to 6% of your capital, and are paid directly to the mutual fund company and dealer. That’s money out of your pocket!

2. Hidden Fees

Second, mutual funds are also expensive with the hidden fees that are not so obvious to investors. These fees are termed the MER (Management Expense Ratio), which also includes the Trailer Fee. In Canada, mutual fund fees are much higher than they are in the U.S. and Canadian investors are simply getting burned.

The Trailer Fee (which is part of the MER) is paid directly to the broker as a kick-back for selling the fund. Additionally trailer fees are also paid as an ongoing benefit to mutual fund dealers, depending on the value of a fund’s holding across the dealer’s client base. These are a small percentage, nonetheless add up over time. Essentially, the longer you hold your mutual fund, the more trailer fees you are paying to your advisor.

The MER, called the Management Expense Ratio, is an annual and ongoing fee that is charged from the fund’s income and profits. It pays for the fund’s management and administration, trailer fees, and also includes all the costs of marketing and promotion for the fund.

According to an article in the Globe and Mail back in March 2011 by Rob Carrick, The average Canadian equity mutual fund had a whopping annual MER of 2.43%! When you combine the MER with the included trailer fee, the average Canadian investor is likely paying around 2.5% to 3.0% annual fees to own a mutual fund. These fees are paid on top of any other front-end or back-end commissions. These fees are paid regardless how well or how poorly the fund performs.

The real irony is that investors pay all these fees, compounding year after year, whether the fund does well or performs poorly. 

3. Under-Performance

The Power of Passive InvestingWhile mutual funds are a win for the companies who manage them and the brokers who sell them, most Canadian investors are paying a premium for under-performance. According to the 2011 ETF Landscape Review, only 15.1% of actively managed mutual funds in the Canadian Equity category were able to outperform the S&P/TSX Composite Index according to S&P.  Further study would be warranted to see how many of those funds were able to continue beating the benchmarks. When you consider the large annual MER fees, trailer fees, front-end or back-end commissions mutual fund companies charge, there is simply no excuse for paying for under-performance.

A great book covering the overwhelming evidence from the under-performance delivered by U.S. mutual funds, is Rick Ferri’s new book, The Power of Passive Investing. In his post for Financial Literacy Day, Avrex Money dove into the issue of under-performance and the high fees associated with actively managed mutual funds. One of my favourite bloggers, MoneyCone, also examined the under-performance issue of U.S. mutual funds in The Fund That Beat The Market 9 Times Since 1999.

Award winning author Andrew Hallam, also covered the pitfalls of the mutual fund industry in depth, in his bestselling book Millionaire Teacher. According to his research, Canadians are at the last spot at 18 out of 18, paying the highest mutual fund fees in the entire world! (Millionaire Teacher, pg.54) Andrew quotes the fund fees that Canadians are paying around 3.0%, compared to U.S. mutual fund fees around 1.5%. I interviewed Andrew back in June 2011, before his book was officially published across North America, in The Millionaire Teacher.

If you are currently investing in mutual funds, and think you are doing fine, then I urge you to get a copy of Andrew’s book, and Rick Ferri’s recent book as well. You will be glad you did. ;)

Conclusion

In this day and age of low-cost ETFs (Exchange Traded Funds) and low cost Index Funds, paying a premium for under-performance with actively managed mutual funds just doesn’t make for good returns.  Actively managed mutual funds in Canada not only under-perform and under-deliver, they cost a lot too!  Although U.S. investors pay at least half of what Canadians do, actively managed mutual funds still diminish your returns through ongoing fees, commissions, and under-performance. You can do much better with low-cost ETFs, low-cost Index Funds, and dividend paying stocks. ;)

Readers, what’s your take? Are you still investing in actively-managed mutual funds? Have you considered the alternatives?

25 Responses to “Why Canadians Should Avoid Mutual Funds”

  1. hahahaha What the Fund?!? Love it! I think this post should be “Why you should avoid mutual funds” because I believe this spans outside of Canada as well.

    Reply to this comment
  2. Financial Planning Guy

    Jan 13. 2013

    One clarification. Trailer fees aren’t paid out on top of MER’s. MER’s are inclusive of all the ongoing fees associated with running the fund including the trailer’s to the dealer. They are also posted on almost all the literature associated with the fund. The 2.43% would be inclusive of this. MER’s in Canada are higher than the states for the same reason cell phones contracts are higher. The market is exponentially larger in the States. While there is no question Canada has to get these fees down it’s not quite a fair comparison.

    Reply to this comment
    • The Dividend Ninja

      Jan 13. 2013

      FPG, thanx for the clarification of Trailer Fees being included in the MER, which indeed they are. I will fix that part/parts of the post. ;) A few points:

      (1) Trailer Fees come out of an investor’s pocket to compensate dealers.

      (2) MERs are indeed posted in the financial material. Unfortunately the vast majority of people have no idea what they are, or that there are less costly index fund, and index ETF options available to them. (i.e. TD eSeries and various iShares products).

      (3) Larger market or not, Canadians have the highest fund fees in the world, out of 18 comparable countries. The only possible explanation I can think of is becuase they are allowed to, not because of popluation.

      Thanx for dropping by!
      Cheers

      Reply to this comment
  3. Rob

    Jan 14. 2013

    I sat down with my sister inlaw and pointed this out to her, showed her the yield on TD Bank, I think, then the MER on her MF and then the math. Who made the money. Anyways eventually she did go to the bank and the reaction of the person across from her showed that very few people ask about this. 20 mins of searching she manged to find some cheaper funds, not the cheapest but better.

    I also did some checking and TD offers some 20 different fund families most of the expensive variety.

    Reply to this comment
    • The Dividend Ninja

      Jan 14. 2013

      Hi Rob,

      If your sister in law is with TD Bank, then she can setup an eSeries account, and invest in the low cost eSeries index funds, The MER is only 0.3% for the equity funds. The eSeries is the best route to go!! See this post:

      http://www.dividendninja.com/start-investing-now

      There is no use just investing in other mutual funds with lower MERs if the performance isn’t there to warrant it. ;) Also remember the annual return of a mutual fund, is already including the MER.

      Cheers

      Reply to this comment
      • Rob

        Jan 16. 2013

        Great article, I loved the way you showed how 25 bucks a week can compound.

        Reply to this comment
  4. Rob

    Jan 14. 2013

    Found this on Susan Brunners blog

    I own this stock (TSX-BMO, NYSE-BMO). This was the first bank stock that I bought and I have had it since 1983. Since 1987 my return has been 15.86% per year with 6.42% from dividends and 9.44% from capital gains

    Don’t know anyone who can say that about a mutual fund

    Reply to this comment
    • The Dividend Ninja

      Jan 14. 2013

      Rob, yes it makes much more sense to buy the banks directly instead of invesitng in their products!

      For a mere $9.99 trade fee to buy, you get the full dividend income which is 4.6% annual yield for BMO, the increase in share price which will occur over time, and no MERs or commissions. I staretd with RY, and I now have BNS and BMO as well. No regrets here. ;)

      Cheers

      Reply to this comment
  5. Good posts! Actively managed mutual funds have done nothing for me …

    However, it’s really hard to avoid mutual funds … My company plan is based on mutual funds so I can’t avoid it unless I want to say no to my company 50%-100% matching contribution. Most company with a plan will be associated with a company that sells mutual funds to provide such plans. More companies are going to be like that for the pensions at private companies. Albeit they advertise lower fees as managed by the plan.

    As such, I go with index funds (which are still Mutual Funds technically speaking) for that account but I am completely out of mutual funds (including index funds) for my other accounts as of October 2012.

    Reply to this comment
    • Note that when the plan was first provided, there were no options for index funds. I had to invest for 5 years without it. Now it does, and I transferred everything in the index funds.

      Reply to this comment
    • The Dividend Ninja

      Jan 14. 2013

      Hi PIE! Yes, this is going to be a common problem with many people who have Defined Contribution Plans, and will be forced to invest in specific mutual fund companies as part of that plan.

      What are the index funds you had to invest in with your plan, and what are the MERs like?

      Cheers

      Reply to this comment
  6. My Own Advisor

    Jan 14. 2013

    Fees kill returns.

    So, own the banks, not the banks products :)

    Good post – to bring more awareness to this issue!

    Mark

    Reply to this comment
  7. Dan Mac

    Jan 14. 2013

    I was recently reading the new book about Warren Buffett titled Tap Dancing to Work. In it there is an article written by Warren Buffett where he discusses how fees affect investors. We invest in business and that businesses growth should effectively give us our return at roughly the same rate. However, because we frequently turn to experts to help us invest they are taking their share so we in effect actually earn lower returns than the companies we own. And the more layers you add to the equation the more “experts” are getting thier hands on our pie. Frequently mutual funds are purchased through a financial advisor who takes his piece, then the fund manager will take his fees and the broker who the manager is trading with will take his portion as well.

    This is why I like to invest directly in individual stocks through a cheap online brokerage. It is the best way to keep these transactional costs to a minimum.

    Reply to this comment
  8. Gerald

    Jan 18. 2013

    Wow, all comments agree with you. That’s like a presidential vote going 90% or more to one candidate…I know two funds that routinely and safely best an index ETF….sure the fees are low….they should be, no mngt whatsoever. Just hate the performance when I can easily find dividend oriented funds that do better….if Wayne Gretzky was running a fund and charging 5% and net of MER’s it outperformed an index ETF I’d be all over it. I guess I’m just saying some funds do outperform, safely, somewhat regularly….why paint all with same brush?

    Reply to this comment
    • The Dividend Ninja

      Jan 18. 2013

      Gerald, good comment. ;)

      There will always be funds that beat the market, that’s a given. The problem is only 10% of 15% of actively managed mutual funds actually beat the market in any given year (as per iShares ETF Landscape review). The likelihood that a fund will continue to outperform the market year after year is even more unlikely. WHo can possibly know which one will win?

      The odds that an investor will be able to pick the winning funds ahead of time, and get market returns is slim to none. Most investors (some 85% to 90%) will pick funds that underperform the market, and pay extra fees for the privelage.

      Given those odds I’d rather buy XIC or XIU, with a very low MER, than try to guess whch mutual fund might beat these index funds. So I’d rather play the market odds than try to bet on a mutual fund manager.

      Actually I just buy dividend stocks directly and own what the funds own without all the fees.

      Cheers!

      Reply to this comment
  9. A lot of investors pay these high mutual fund fees, because they have no financial education. And the people that “sell” these products have created the impression that only the “investment professionals” know what they are doing. Most people saving for retirement are really confused and do not represent the audience of Dividend Ninja at all.

    I doubt this would change. As a result, I think the best investment is not in mutual funds/etfs, but in the company’s that sell them. Having recurring fees on an ever expanding asset base is the ultimate model for long-term dividend growth.

    Reply to this comment
  10. Mike

    May 22. 2013

    Hi,

    I know I am a little late to this thread but I was wondering if you could give me some advice as I am relatively new to the investment game. I have a LIRA from my former employer in the range of $65K to invest as I see fit and have many decades to retirement. As you know, LIRA’s are locked in and cannot be added to. So of course my first thought was to invest in a solid balanced and inexpensive mutual fund like Mawer or Steadyhand. But your post indicates that this may not be optimal. Do you have any suggestions for a mix of ETFs that would be suitable keeping in mind that the long timeline (25 years) and the fact that I cannot increase the amount I invest in the LIRA

    Thank you

    Reply to this comment
  11. Sara Bonham

    Feb 28. 2014

    Great article!

    Just wish it was more mobile responsive :)

    Reply to this comment

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