Volatile markets put new shine on mutual funds

Mutual funds have lost much of their lustre as financial instruments over the past 10 years or so as a result ofvolatile markets andthe range of new options available to savvy investors and amateurs alike. But some financial experts say the tough markets are actually helping to bring mutual funds back into fashion again.

Compare those options with buying into a mutual fund that represents a wide range of stocks, offers somewhat stable returns and generally moves in value with all the speed of an oil tanker.

'You'll have criticism saying that diversification isn't the answer, that when the market's highly volatile you don't have those correlations anymore of diversification and safety.' Andrew Beer, Investors Group

In the 21st century, mutual funds might not appear to be very leading-edge. But investors need to think twice, especially in these difficult financial times, before throwing away the slow and stable for the flashy and volatile, experts say.

"With a mutual fund, you can have the common investor have access to hundreds of different stocks, so there's safety of diversification," said Andrew Beer, manager of investment planning at Winnipeg-based Investors Group.

A caution, however, for Canadians starved for some return but terrified of volatility: These vehicles aren't necessarily the old, reliable answer to the new era of financial uncertainty.

"You'll have criticism saying that diversification isn't the answer, that when the market's highly volatile you don't have those correlations anymore of diversification and safety," Beer warned.

Golden years

Back in their heyday during the 1990s, mutual funds might have been considered the "big boys" of Canada's investing neighbourhood. In 1999, Canadians' net purchases of mutual funds (after accounting for redemptions) hit more than $35 billion. And that stellar showing was in the first year after a major global money crisis that was precipitated by a handful of tumbling Asian currencies.

Instead of shunning mutual funds as the recovery took shape, Canadians were buying these investments in ever-increasing numbers.

Two reasons for the popularity of mutual funds in that decade were that financial buyers had fewer investment options and had become increasingly wary of purchasing single stocks. Canadians were attracted to mutual funds, essentially big pools of cash in which professional managers traded a wide range of stocks and bonds and followed the ins and outs of the major stock markets with all the attention of a hawk searching for prey.

So, instead of buying shares in only a few companies, investors were able to spend roughly the same amount of money and get a tiny piece of a vastly larger number of corporations.

In effect, buying so-called mutt funds gives people access to the shares of more companies, professional management and reduced valuation risk. Not a bad combination for Canadians worried about retirement.

Too much of good thing

Mutual funds quickly became seen as a "fail-safe" investment, one in which you were almost always going to show gains, and the sector was beset by overselling.

After all, as long as each individual fund was diversified and an investor held a number of different funds, he or she should be able to nearly eliminate downside movement across an entire portfolio. While any one fund might drop in value, the chances that all holdings in one's portfolio would head in the same direction were tiny, it seemed.

Unfortunately, the spectacular depreciation of technology stocks in the year 2000 ended the belief that diversified equity holdings will always outpace a stock market downturn.

"There was a huge explosion in the '90s," Beer explained. "But then came the tech bubble and it caught a lot of people off-guard. They hadn't really lived through something like that, and then they got a little gun-shy."

There was also the raft of scandals in the industry that were uncovered in 2003. A number of funds engaged in a variety of illegal practices such as late trading, buying fund shares after the 4 p.m. close of the trading day to drive up their performance figures.

At the same time as mutual funds were coming to be seen as an emperor with no clothes, other financial vehicles, such as exchange-traded funds, became more prominent and easier for retail investors to obtain.

Exchange-traded funds are a prime example. Like mutual funds, ETFs hold a variety of shares, but they trade on a stock exchange where any investor can buy them, and typically consist of equities that reflect a stock index like the S&P 500 or TSX 60. Because they tend to be passively managed, the fees investors have to pay to fund managers are far lower.

As a result of all these factors, Canadians have cut their mutual fund purchases substantially. Net sales of mutual fund units for the 12 months ending Oct. 31, 2011, were $19.6 billion, according to the Investment Funds Institute of Canada. That represents a doubling of the prior-year figure of $9.6 billion, but is still way down from the heady levels of the 1990s.

Funds have value

But what was true about mutual funds back in the 1990s remains true in the new millennium, argues Carol Bezaire, vice-president of tax and estate planning for Mackenzie Financial Corp., a large mutual fund company.

"With mutual funds, you have a chance to buy a whole bunch of different things," she says.

For example, to buy a share in the Royal Bank of Canada would cost about $50. To purchase 100 shares, the usual minimum for a normal stock transaction, would cost $5,000.

By contrast, buying $5,000 in shares in a mutual fund that owns RBC will snag the investor a portion of the returns from Canada's biggest bank plus a number of other companies.

In addition, a person buying stock in individual companies needs to follow the companies themselves to properly monitor the performance of their portfolio. Buying into a mutual fund means you get a manager who watches these companies on a daily basis, Bezaire notes.

Killer fees

The problem is that managers overcharge for their services, according to David Chilton, author of the popular financial book The Wealthy Barber and now a sequel, The Wealthy Barber Returns.

While fund managers get paid in a variety of ways, one of the most common is what's known as the management expense ratio, or MER. That's the percentage of the fund's assets that goes to the fund manager, before any returns are given to unitholders.

A recent study by fund monitoring company Morningstar found that Canadian mutual funds have a median MER of 2.31 per cent. That's higher than those in most developed economies, including the U.S., where funds have a median MER of 0.94 per cent.

'There's pressure on the industry now to bring fees down, and probably that's a good thing.' David Chilton, author of The Wealthy Barber

"There's pressure on the industry now to bring fees down, and probably that's a good thing," Chilton said. The author adds that there's no good reason for a Canadian equity fund to charge in excess of two per cent to buy widely available large-cap dividend-paying stocks. "That's nutty," Chilton said, "and I don't meet anybody in the industry who denies that's nutty."

Fortunately for investors, the other types of fees associated with mutual funds can be avoided and are generally disappearing from the market. So-called front-end loaded funds (also known as "initial sales charge funds") levy a commission up front when you buy units. It's usually a percentage of the value of your purchase, and typically ranges from 2.5 to 5.75 per cent.

Back-end loaded funds, also called deferred sales charge funds, subtract a commission when you sell your units, though the commission percentage often declines the longer you hold onto the fund and can reach zero after three to seven years. More and more funds these days use a no-load structure, where there's no sales commission when you buy or sell.

Don't be fooled though: The financial adviser who sold you the mutual fund still gets a commission, it's just wrapped into the MER.

Overall, it's still good news for investors and a necessary move to keep mutual funds competitive with other products. As a result, mutual funds might be able to put a little shine back on their tarnished image.