As a “VIP” of a local bank, I was invited to a room where a senior manager talked to me about their new exciting investments in “high return” funds. One of the funds yielded 15% in 2009, and it has been the crown jewel of the bank. As an investor myself, 15% return is very attractive; therefore, I proceeded with a few questions. However, when I asked the senior manager about the return of the benchmark, the conversation literally ended there, and he stood up and left. Knowing the fund has at least $3 billion dollar asset under management (AUM), I feel bad for people that don't know what they are getting into.
As I am writing this article, the stock market is breaking through its previous peak and enters a new high; as a result, I am often approached by people who want my opinions on mutual funds. The truth is almost all mutual funds are bad investments, and everyone should avoid it (unless it is for tax purposes). After repeatedly seeing my friends and family fall into the same trap, I will talk about why mutual funds destroy your return and where you should allocate your investments.
I can go on and on about mutual funds, but I will stick to the top 5 things to give you an idea of what you are buying.
1. Fund managers take profits, you take losses.
With mutual fund investments, fund managers take a portion of your total investment, whether funds make money or not. The system they run is called Managerial Expense Ratio (MER), and it acts like a protective provision to guarantee banks to make riskless revenue no matter what happens to the market. Additionally, because fund managers’ payroll isn’t tied to fund return, they make very little effort into helping you make a profit.
2. Active funds destroy value.
The recent Nobel Prize winner, Dr. Eugene Fama, mentioned in his award winning paper that the average returns of all mutual funds are -2%, which are the same amount as what mutual fund managers charge you. Thus, funds in general do not generate returns beyond their respective benchmarks. Yet, we have to pay fund managers to manage funds that do not outperform the market.
The reality is very much aligned with his observation. For instance, TD’s Comfort Balance Growth Portfolio yielded 10.66% within 1 year, but the fund alpha is -3.36%.[1] The number implies that the fund manager’s professional expertise contributed -3.36% to your return, and the 10.66% return you get is the compensation for the risk you are taking.
The 3.36% is only a portion of the money they take away, the other major portion is the MER. Altogether, the difference between this mutual fund versus a passive benchmark ETF adds to over 5% annually. This means 5% less return for your portfolio and for reinvestments.
3. Double MER.
What many people don't know about most of mutual funds is that people often pay MER twice for a single fund. The problem is that most funds are fund of funds, which means that funds in the portfolio charge MER first, and then the residual return is subject to another MER. Take TD’s balanced portfolio, for example, funds in the portfolio charge an average of 2% MER. Afterwards, the fund itself charges and extra 1.92% MER, therefore, you lose approximately 3.92% return to fund managers every year no matter what amount you gain or lose. [2]
4. Small numbers deliver big results.
In the example that I have provided above, If you started with $1 million of funds in the portfolio generated 15% return altogether, after a 3.92% MER, only 11.08% goes into your pocket. The 3.92% loss every year can snowballs into a massive investment loss, and the effect is illustrated in the chart below.
You lose more than $1 million (119% of your original investments) in the fund of funds scenario over a period of 10 years.
5. Funds make inaccurate claims.
When I was sitting through Primerica’s orientation, they claim that they copy the most successful mutual fund in the market in order to replicate their return. Rather than showing me what Primerica funds have generated, they showed me what other banks’ funds have generated and claimed it as their potential return. If the strategy of “Copy and Paste” worked, everyone should be as rich as Buffett.
Take away:
Nobody cares about your money more than you do. You should plan your investments and trust yourself with your investment decisions.
How should you do it?
There are two methods that you can get around mutual funds; you can either invest through ETF or invest in stock markets. However, if you believe you have superior information or feel confident at security selection, then you should devote yourself to stock markets.
Controlling risks
Mutual funds claim they diversified their portfolio very well, but when you look at their portfolio contents carefully (refer to picture below), how are these funds diversified at all? It is merely a mixture of energy stocks combined with financial stocks.[3]
When you try to diversify your portfolio, you should invest across different sectors (Finance, technology, natural resource), different nature of business (Gold, private equity, import/export), different asset classes (Equity, bond, real estate), and different geographic area (Australia, US, China). A total investment in 15-30 stocks can minimized the idiosyncratic risk from each individual stock.
Choose what you buy
Now you know how to control the risk you take, you can select securities you want in your portfolio. As mentioned in the previous blog, the best way to identify stocks to purchase is through reading market sentiments, which can be extracted from reading charts and people’s recommendations. There are plenty of websites that support this function, and they can help you make a great decision.
Wrap up
Hopefully you would avoid mutual fund investments after reading this blog. To me, it makes no sense to put your money in mutual fund, but I understand it gives people a hint of security. However, in the world of mutual funds, security comes with a heavy price. Mutual funds are structured to provide security to banks’ operations at your expenses, which is exactly opposite of what you wanted when you make an investment.
If you have any question, please leave a comment in the blog or contact me at fred@nvest.me.
Fred Zhou
