Would the Real “Fund” Please Stand Up!

In 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.

The Landscape Review (Canadian ETFs)

Candian ETFs - Click to enlarge

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 (see chart to left), 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.”

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33 Responses to “Would the Real “Fund” Please Stand Up!”

  1. MoneyCone

    Jul 13. 2011

    Excellent introduction to funds! I love ‘back to the basics’ posts such as these. Reminds me of the time I struggled to grasp these concepts when I started investing.

    Reply to this comment
  2. dividendingenieur

    Jul 13. 2011

    Nice basic introduction Ninja. Back to the roots.

    Reply to this comment
  3. The Dividend Ninja

    Jul 13. 2011

    MoneyCone and DividendIngenieur, thanx for posting! 🙂

    Reply to this comment
  4. Susan Brunner

    Jul 13. 2011

    Part of the problem I see in Mutual Funds is that when the market is climbing, people pile in their money and force the fund manager to buy stocks at increasing prices. When the market is falling, people then take out their money and the fund manager has to sell at inopportunte times.

    The above would force a fund manager to buy high and sell low, the opposite that should be done. Any investor in a mutual fund for the long term will suffer because of this.

    Reply to this comment
  5. The Dividend Ninja

    Jul 13. 2011

    Hi Susan,

    Thanx for dropping by :)You’re absolutely right! Becuase the majority of investors buy when times are good (rising markets), and sell when times are bad (declining markets), they do indeed cause mutual fund managers to purchase and sell assets at the wrong times. Andrew Hallam just published part of his new book in the current MoneySense issue, and he covers exactly this point.

    However mutual fund managers are also under a lot of pressure to perfrom. They also will chase after hot stocks and sell losers, in attempt to boost returns. Combine all of that with high MERs (management expense ratios), trailer fees, and commissions – it’s no wonder people don’t make much money in mutual funds.

    The majority of investors would be far better off buying an Index Fund like TD Canadian Index e-series, add onto it regularily, and do absolutely nothing. They would beat the majority of actively managed Canadian Equity funds over and over. In fact, I have the research to prove it, and will be publishing that post in a couple of weeks or so.

    Cheers! 🙂

    Reply to this comment
  6. Jon Evan

    Jul 13. 2011

    I don’t own etfs. They remind me of early era mutual funds where I got burned once and not just because of the MERs. The companies who sell them aren’t middle men but they act for their own interests to make money from your money and there is the rub.

    So, take the TD Canadian Index fund that you mention. I thought it was a plain vanilla passive index fund owning a basket of equites, but a quick look at the prospective and I get frightened! “The Fund may engage in securities lending, repurchase or reverse repurchase transactions…” These it warns pose a risk for the investor and there are other risks such as “derivatives risk”, “large investor risk”, “series risk and tracking risk.” I don’t understand some of these but they remind me of the mutual fund complexities where once I lost money. The companies who sell etfs don’t just sell the plain ones but the newer ‘synthetic’ etfs carry greater risk not only for the investor but also for the company which engages in them because for the company the newer etfs are the cash cows but at greater risk! Could a lehman brothers bankruptcy happen to Blackrock for example because of these newer etfs going bad? I think I will stick to value dividend pay stocks which have worked for me as part of my equity portfolio. I’m not interested in beating any index just saving some reasonable bit for retirement in things I personally better understand. But it’s not for everyone.

    Reply to this comment
  7. Dividend Mantra

    Jul 13. 2011

    Thanks for the descriptions and getting “back to basics” Ninja! Much appreciated.

    As I’ve said before, no matter how low cost a fund might be I think I’ll do better on my own by investing in dividend growth stocks.

    But, I wish all my passive brothers out there the best of luck with any funds they might invest in!

    Take care.

    Reply to this comment
  8. The Dividend Ninja

    Jul 13. 2011

    Hey Jon,

    You bring up an interesting point. I did look up the fund profile, since I have a copy at my desk, and indeed see exactly the points you mention. I don’t like seeing the word “derivatives” either, though I think these types of options and futures have been used for a long time, in small positions. Let me dig a little deeper and see what I can find out. Tracking risk is simply the percentage difference between the index and fund performance.

    In terms of the latter ETFs you describe as “synthetic” ETFs, I discuss those more in Part-2. And I would agree with you, many of these products are unsuitable for most investors for a number of reasons.

    Cheers

    Reply to this comment
  9. The Dividend Ninja

    Jul 13. 2011

    Mantra thanks for dropping by 🙂 I think you have the dividend investing strategy pretty down-pact to a science, if not an art! Keep up the good work mate.

    Reply to this comment
  10. Canadian Couch Potato

    Jul 13. 2011

    @Jon Evan: A lot of mutual funds use index futures or ETFs to stay fully invested when it isn’t practical to buy the stocks in the index in small amounts. This is a cost-effective way of dealing with excess cash (from recent inflows, dividends, etc.) so it doesn’t cause a drag on returns.

    There is no meaningful risk here. Index futures have been around forever, and they’re traded transparently on an exchange. There is no counterparty risk, and there is nothing at all dodgy about them. I think people just get their back up when they hear the word “derivative,” but not all derivatives are mysterious black boxes.

    The fact is, if you read all of the risks listed in any mutual fund prospectus, you’d never invest in anything. 🙂

    Reply to this comment
  11. The Dividend Ninja

    Jul 14. 2011

    MOA,

    Thanx a lot man! More Ninja “chopping” to come, and I am looking forward to your post on mutual funds as well.

    I’m sure there are only a limited number of ETFs that really suit a true index investor, and I would also suggest most of those are from ishares and a few from Claymore. How about you give us a post of your top 12 ETFs? 🙂

    Cheers!

    Reply to this comment
  12. Jon Evan

    Jul 14. 2011

    I think Couch Potato makes a naughty statement (no doubt tongue and cheek): “The fact is, if you read all of the risks listed in any mutual fund prospectus, you’d never invest in anything.”

    He is right that reading a prospectus is frightening: full of legalese!
    I suppose I was naive to think that a plain vanilla index fund simply just held a basket of stocks when in fact the company uses those stocks to actively make extra money! If “securities lending” is a normal practice then the fact the prospectus calls it a “risk” to the investor sounds like there is some kind of counterparty risk involved.

    This etf business started out altruistic (I think) and may still be that for the most part with gov’t regulations mostly protecting investors but there is increasing chatter to the effect that our money is being used behind the scenes by etf providers for their own profits and that kind of activity can get out of hand. See what’s happening in Europe:

    http://ftalphaville.ft.com/blog/2011/07/11/617516/if-you-pay-peanuts-for-etfs-you-get/

    Reply to this comment
  13. Andrew Hallam

    Jul 16. 2011

    This is a great post Ninja!

    I’m quite surprised at the value invested in ETFs versus actively managed funds. If I can make a presumptious leap, it might assume that more people with higher valued investment accounts aren’t using actively managed funds, and using ETFs instead. I only base that on the vast majority of people who must be using actively managed funds, but the surprisingly high dollar value in ETFs. Of course, there is less money in ETFs, but the asset values of them surprise me.

    Reply to this comment
  14. DIY Investor

    Jul 16. 2011

    In the U.S. most assets are invested in 401ks, 403bs etc. are mutual fund assets. Only very recently have ETFs been introduced and in fact only recently have self directed 401ks started to become more popular.
    Very useful post. I was told years ago about the advisor who spent 40 minutes describing his investment approach and then asked if there were any questions. The question: What is a mutual fund?
    Many times we throw around jargon we use everyday and assume that the people we are talking with understand what we are saying.

    Reply to this comment
  15. The Dividend Ninja

    Jul 16. 2011

    Robert (DIY), thanx for dropping by!

    That’s an interesting point about the use of jargon. Many people use terminology they don’t understand or assume others do. I always try to write as clearly as possible. So I hope I’ve brought some clarity – even with a bias towards indexing 😉

    I’ll bet you a $5 dollar gift certificate from the Home Depot, that this advisor was able to get most people signed over in 10 minutes. But this person took 40 minutes because they were smarter than most. Had they read your blog first, Andrew’s blog, Rick Ferri,or the Couch Potato, they wouldn’t have gone with an advisor. Cheers!

    Readers: If you are not familiar with Robert Wasilewski, he is an investment advisor in the U.S. who promotes low-cost index products over actively-managed mutual funds. He writes very clear and helpful posts. You can read his blog at:

    http://rwinvesting.blogspot.com/

    Reply to this comment
  16. The Dividend Ninja

    Jul 16. 2011

    Andrew, thanx for posting!

    I’m not surprised to see the higher percentage of investment dollars in ETFs in Canada. It would be interesting to know if your premise is correct – it probably is 🙂

    I just read (in the current issue of MoneySense) that Canada has the highest mutual fund fees of all the G7 Nations. On top of that I think the word is getting out on “index investing” in large part to MoneySense and the Couch Potato.

    What is unfortunate however, is that doesn’t suggest people are investing smarter. Of that 41.9 billion, only 22% is in fixed income ETFs. That means investors purchasing ETFs in Canada are probably loading up more on equities. We all know how the “dog on the leash” catches up with itself, as you point out in your MoneySense article 😉

    Another interesting tid-bit from the ETF Landscape Review on Canadian ETFs:

    “In Canada for the Second Quarter of 2010, only 15.1% of active mutual funds in the Canadian Equity category were able to outperform the S&P/TSX Composite Index according to S&P.”

    btw: Great job with your book excerpt in MoneySense Magazine! Millionaire Teacher is going to be a big hit.

    Reply to this comment
  17. Andrew Hallam

    Jul 17. 2011

    Thanks Ninja!

    You might find it interesting that the high cost advisor I wrote about before has given a rebuttal to my post/our comments. I’ve posted it, with responses. Come on over. Would love to hear your 2 cents!

    Andrew

    Reply to this comment
  18. The Dividend Ninja

    Jul 17. 2011

    Hey Andrew, I saw the follow-up – I’ll be over as soon as I can with a detailed response 🙂

    Cheers!

    Reply to this comment
  19. The Wealthy Canadian

    Aug 02. 2011

    Great job providing an excellent explanation about the different types of funds that are available to investors.

    In terms of my own personal preference, I do not buy mutual funds – ever. I do have direct positions in companies like IGM Financial and Great West Life because, as you have clearly outlined in this post, we know that mutual fund expenses are high in Canada. IGM & GWO pay great divvys and I like to make money from the masses that are investing in mutual funds.

    For the most part, I invest in stocks directly.

    With that being said however, I have recently been buying positions in ETFs for diversification purposes. If there is an international based company that I am interested in investing in, but the company is not listed on any of the North American exchanges, than it meets my criteria as a possible purchase.

    If I’m not mistaken, this would fall in line with one of your Ninja Rules – Rule # 3: Diversification.

    ETFs have a place in my portfolio; however, they need to meet my criteria for diversification as it relates to foreign content.

    Nice post! Looking forward to part II.

    Reply to this comment
  20. The Dividend Ninja

    Aug 03. 2011

    @Wealthy Canadian

    Thanx for posting 😉 I always appreciate hearing from established investors with a proven track record, and the wealth to prove it.

    I don’t invest internationally, as I feel it adds more risk to my portfolio – not less. That’s just my opinion, but I feel I get enough diversification between U.S. and Canadian companies. My reasoning is the big U.S. companies are already global empires anyway (i.e. McDonalds, Johnson & Johnson, etc.)

    However there are certainly some European and Asian companies I would gladly invest in such a Nestle, Hyundai, etc. if I had the capital.

    Cheers!

    Reply to this comment
  21. The Wealthy Canadian

    Aug 14. 2011

    I hear you.

    Over the past months, I’ve been trying to build upon my US equity positions.

    I also like being able to diversify internationally by investing in companies that are listed on the US exchanges or through ETFs.

    BTW – I just found your reply to my original comment in my spam folder so sorry for the long wait! 🙂

    Reply to this comment
  22. Christine LeBlanc

    Sep 26. 2011

    Great article, but I noticed Danielle Arbuckle’s surname is missing! I’m a fan of hers, but it also stands out because every other columnist is mentioned by full name.

    Reply to this comment
  23. The Dividend Ninja

    Sep 26. 2011

    Christine LeBlanc No problem I added her surname in.

    Reply to this comment
  24. Jill

    Mar 17. 2012

    Hi there,

    Great article – and site! But I don’t see the link to Part 2 – could you post the link here?

    Many thanks,

    Jill

    Reply to this comment

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