Why You Should Avoid Mutual Funds

Piggy BankFor Canadians, November is Financial Literacy Month! That’s right, a whole month dedicated to educating and helping Canadians to become more financially independent, and more aware of their finances.  This national media campaign is spearheaded by Glenn Cooke, of LifeInsuranceCanada.com. The goal for bloggers is to give their best financial tip.

My tip is why you should avoid mutual funds.

Over on the Dividend Ninja, as part of the Financial Literacy Month 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 sizeable 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 Canadians, since they are not heavily marketed – in order to keep the costs low.

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 underperformance. Although U.S. mutual funds have lower fees, almost half of what Canadians pay, here are the reasons why you should avoid mutual funds.

What the Fund?

Back 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.

Why You Shouldn’t Buy

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 including Trailer Fees
  • Underperformance

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, and are simply 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 or readily disclosed to investors. These are primarily the MER (Management Expense Ratio), with the included Trailer Fees. In Canada, these particular mutual fund fees are much higher than they are in the U.S. and Canadian investors are simply getting burned.

The Trailer Fee ( 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. This is an annual and ongoing fee that is charged from the fund’s income and profits, to pay for the fund’s management and administration. That also includes all the costs of marketing and promotion. According to an article in the Globe and Mail back in March 2001 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%+ annual fees to own a mutual fund. These fees are paid on top of any other front-end or back-end commissions. The real irony is that investors pay all these fees, compounding year after year, whether the fund does well or performs poorly.

3. Underperformance

While 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 underperformance. 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.  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 underperformance.  

One of my favourite bloggers, MoneyCone, recently examined the underperformance 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 [easyazon-link asin="0470830069"]Millionaire Teacher[/easyazon-link]. 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 at around 3.0%, compared to U.S. mutual fund fees of 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 – 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 underperformance with actively managed mutual funds just doesn’t make for good returns.  Actively managed mutual funds in Canada not only underperform 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 underperformance. You can do much better with low-cost ETFs and low-cost Index Funds. ;)

18 Responses to “Why You Should Avoid Mutual Funds”

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  1. Avrex says:

    thedividendpig, I love this post because, well…. It was also my ‘best financial tip’ that I could give to my readers. :)

    It is a very important issue, as I believe the high costs are eating away investors retirement savings Investors need to be made fully aware of these costs.

    I’m glad that you highlighted this issue today.

    • Avrex, your post is awesome!

      I cannot believe how many people I know are still investing in actively managed mutual funds. The more word that gets out on this important issue, the better informed people will be. ;)

      Cheers

  2. Great post Dividend Ninja! I’d like to finish your last sentence if I may :)

    “You can do much better with low-cost ETFs and low-cost Index Funds” and also with buying individual quality dividend paying stocks.

  3. Rob says:

    Hi Ninja,

    Yeah, high MERs like that can be pretty scary, and your article and tip makes a great point. A 1.5-2% difference in return on your investment (high MER mutual funds versus low MER ETFs) over the course of 20 or 30 years can lead to a huge amount of money. What investor wouldn’t love to make +1.5% more each year? That’s effectively what you’re doing by switching from mutual funds to ETFs, and is exactly what I did a few years ago. Like so many others I initially invested in mutual funds because that’s what my previous employer offered, and I didn’t know at the time that there were other options open to me. Thanks for further promoting financial education.

    • Hey Rob, if only it was only a 1.5% difference, which still has an enourmous impact on returns. It’s more like a 2% to 2.3% MER difference, without including any other fees or commissions!

      Don’t worry, almost every DIY investor out there started out in mutual funds. That’s why they are DIY investors now! :)

      Cheers

  4. Martin says:

    This is the exact reason why I eliminated mutual funds from my portfolio. It is a losing game. There might be people out there who do not understand investing much or want to invest and then forget and therefore they chose funds, or we have them in our 401k plan, but besides that, I would never invest in them again.

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  2. [...] The bottom line is you can easily find the extra $25 per week, pay yourself first, and start investing for big gains! I also want to show you how you can use the TD e-series funds instead of actively managed mutual funds, and save yourself a fortune in fees and commissions.  Although most people invest in actively managed mutual funds, it’s completely negating their returns, through fees and commissions. I covered this topic over on the Dividend Pig, in Why You Should Avoid Mutual Funds. [...]

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

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