May 10 Beyond Funds Radio Show

Beyond Mutual Funds


Show Content, May 10, 2008


Good morning…this is ScotiaMcLeod Wealth Advisor Jeff Wareham, with Beyond Funds Market Weekly, for May 10, 2008.


Is it just me, or has virtually no one noticed the resurgence of the Canadian market...the TSX came within 100 points of it's all time high thursday, and no one seems too excited...the charging recovery in the Canadian market has not been accompanied by a similar resurgence elsewhere, as most global markets are well off of their all time highs...Toronto’s TSX closed the week at 14521, while the dow in New York ended the week at 12745, more than 1000 points below its all time high of 14001, and the Nasdaq finished at 2445, less than half of its record of over 5000 during the tech bubble. The Standard & Poors index finished the week at1388, about 11 percent from its all time high, reached last fall.


Again this week, the record breaker was crude oil, finishing at 126.03, up about 700 percent in the last ten years.


Gold remained below $900 per ouce, finishing at 887.80, driven lower by a slightly stronger $US, which finished the week at 100.59 versus the Canadian Dollar.


So Toronto appears a shining light in a globally uncertain market...and this presents an opportunity for Canadian investors to look globally, and diversify into other solid markets that may take longer to recover…let me share some thoughts on why…


A disciplined investment process begins with determining the asset mix that is right for you. Life, markets and your portfolio all change with time, so decisions made yesterday may not hold true with new information tomorrow. This is the reason that your investment strategy is not just about the markets. When you buy a house, have a child or approach retirement your investment goals will change. As your goals change, so might your asset allocation. For example, the asset allocation of a very aggressive investor would not be suitable for someone who is retiring in the coming years. Just as major life events change us, we can also look at major market events as changing the way we look at our portfolio. For some investors this may be an opportunity for reflection. You may ask yourself if your “normal” asset allocation is still valid once you have considered any changes in your life. If that answer is yes, then when markets change as they do, it may also be time to consider rebalancing your portfolio back to its original mix.

Because market movement fluctuates between asset classes, it is the natural course for a portfolio to change its look. Asset classes do not change at the same rate. Over time, stocks may grow faster than bonds making the growth in your portfolio uneven. For example a portfolio of 60% equities and 40% bonds could drift to 70%/30%, or alternatively the other way to 50%/50%. Regardless of the direction of the change in your portfolio, it is necessary to remember the importance of the reasoning behind your original asset allocation. Although it may seem counter intuitive to sell in an asset class that is doing well or buy into one that is not that is precisely what is required if the fundamental principle of “buy low – sell high” is to be followed. By rebalancing your portfolio, you are staying the course and increasing the potential to improve returns without increasing risk.

Disciplined rebalancing can provide comfort by taking the emotion out of your investment decisions. It does not seem natural to sell a portion of your investments that have done well and buy more of those that have been more sluggish. This discipline allows a reassuring way to buy when it is difficult and sell…that is, when it seems counterintuitive. When markets are down human nature would have us get out rather than buy low, but a disciplined rebalancing process can prevail in the long run.

Although at times the changes in the market may not be large enough for an investor to feel that there is any need to rebalance, the benefit to doing so can be significant over the long run with compounding returns.


For a beginning investor, doing this is relatively easy. You can sit down with an advisor, either in a bank or an investment planning firm, and discuss with the advisor what you are trying to accomplish. They will likely discuss your options, and recommend a fund or group of funds that may be rebalanced automatically to meet your needs. Most of the major banks, like Scotia, have individual funds designed to meet the needs of beginning investors, and many of the independent firms have funds that are designed to rebalance automatically as you approach your goal…for example, if you are accumulating money to retire in 2025, you might choose Fidelity’s Clearpath 2025, which starts with a higher level of equity, but becomes less and less equity oriented, and therefore aggressive, as 2025 approaches.


This type of strategy is a great starting point, but this show is called Beyond Funds Market Weekly…and let me be clear…I feel that as an investor’s wealth grows, so does their need for more sophisticated, but not necessarily more complicated, financial solution…frequently, this is a solution beyond mutual funds.


Why?


First and foremost is the bottom line…a recent study indicated that 91 percent of Canadian mutual funds fail to meet the benchmark against which they are measured…there is no way to sugar coat it…that is awful. One of the main reasons for this is that fund management fees in Canada are the highest in the developed world…at a bit over two and one half percent, they are approximately double those of the United States. That may seem to be logical, when you consider the relative size of the markets…but this logic fails, when you discover that Australia, with a much smaller population than Canada, has lower annual fees than the Americans, let alone Canada.


That two and one half percent average may not sound too bad…until you consider that the long term average gross return of the Canadian equity market is a bit over ten percent…so 2.5% represents one quarter of an investor’s return on their capital going back to the fund manager…and the impact of that can be staggering. The Ontario Securities Commission produced an excellent web based tool, at www.investored.ca, which allows a fund investor to calculate the impact on their portfolio…and I will happily walk anyone through it one on one…I recently worked through an example, where, based on a pretty average fund expense and rate of return, an investor had paid more in fees after 22 years than they had originally invested! Let me be clear…a $300,000 investment cost over $300,000 in fees!


Funds are a great starting point…for a few hundred dollars, a starting investor gets access to professional money management for a small, invisible monthly fee. An investor paying 2.5% on $500.00 only pays 12.50 per year! What a bargain!


Unfortunately, the process is a bit too democratic…a $500,000 investment gives the investor the exact same access to their portfolio manager, for 1000 times more in cost…in this example, $12500.00


Very few investors want to retire on less than this $500,000 threshold…so this discussion is relevant to most our listeners…after the break, I will share with you ten strategies for investors outgrowing their mutual funds…stay tuned.


Welcome back to segment two of Beyond Funds Market Weekly…I am your host, ScotiaMcLeod Wealth Advisor Jeff Wareham…before the break, I was discussing investor alternatives beyond mutual funds…I do not have time today, but I will briefly discuss each one, and dig deeper into them in upcoming shows.


Here are ten options for investors outgrowing mutual funds…the list is not exhaustive, but it gives you an idea of your options.


Individual stocks, bonds, GICs and cash
Managed money
Discretionary management
Exchange traded funds
Annuities
Segregated Funds
Corporate Class Funds
Structured Products
Trusts
Hedge Funds


Looking at them one at a time


Individual stocks, bonds, GICs and cash


-Traditionally, investors who wished to hold individual stocks and bonds would deal with a stock broker, who charged a commission for every purchase and sale they did. Although many brokers still follow this model, more and more are going to a model where they choose to charge a fee based on the value of the assets that their clients have with them, and do not charge commissions on each trade…both models have their strengths and weaknesses, and some investors even have both types of accounts, depending on what they are looking for…for example, a client may want to pay for equity advice, but prefer to buy only GICs in their fixed income accounts.

-Most brokers are licensed to deal in insurance and mutual funds, and can choose among a variety of investment products depending on the level of involvement an investor seeks, the amount invested, and the comfort of the client with risk.


Managed money


-Some clients may recognize the expensive nature of mutual funds, but may like the due diligence and research of fund firms…for these investors, managed solutions, many of them offered by major mutual fund firms, or even pension management firms, may be an alternative. The investment advisor, in consultation with the client, determines the client’s asset allocation, and entrusts the management of the money to the money management firm. Generally, the fund manager uses pooled funds, and the asset allocation of the funds is rebalanced, by either the manager, or the advisor. Often, the fees are segregated from the fund and billed to the investor, so on non registered money, the investor is much better off, as they may deduct these fees from their other income…a huge advantage for a higher net worth investor.



Discretionary management


-this option involves engaging a Portfolio manager, and in most cases, the investor deals both with their advisor, and with a portfolio manager. The manager uses both pooled funds and individual stocks and bonds to achieve the investor’s asset goals, and the advisor looks after ensuring the financial plan is executed.


Exchange traded funds


As I mentioned…most mutual funds fail to beat the market…an exchange traded fund or index mutual fund is designed to track the performance of a particular index…with the underlying theory being “you can’t beat the market.”

More and more narrowly focused versions of these have been coming to market recently, tracking such narrow indices as ‘twice the negative return of a barrel of oil,” but the most useful ones, in my opinion, are those that track the return of various indices, which offer the opportunity for global diversification without the challenge of selecting the best company in a distant market…global ETFs offer a direct competitor to international mutual funds at a fraction of the cost…although because they have small, embedded management expenses, they will never beat their index, as their return will be approximately the return of the index, less their management fees…so the down side is that they will never beat “the index,” but the up side is that they will never lag the index by a great deal…in fact, most index funds in Canada rank in the top quarter of equity mutual funds…and the ETFs would as well, if they were measured that way.


Annuities


Perhaps the oldest long term investment vehicle in the market is the annuity…investors put a lump sum up front, and receive a fixed payment for the balance of a time period…generally for life…defined benefit pension plans are generally based on annuity rates, and some are actually purchased using an annuity. Low interest rates and inflexibility have left annuities on the sidelines in recent years, but many investors are giving them a second look, especially with non-registered money, as a strategy called the insured annuity has allowed healthy investors to garner a cash flow much higher than the after tax cash flow of bonds or GICs…but this is a very long term strategy, and like every other solution I have discussed, really requires the guiding hand of an advisor.


Segregated Funds

A much newer solution from the insurance world is the segregated fund…which is covered under totally separate legislation than a mutual fund, but is essentially a mutual fund with a guarantee provided by an insurance company…early versions have frequently been plagued by even higher management fees than traditional mutual funds, and some have had such poor performance that the insurance guarantees are likely to kick in over the next few years…and many were designed with very flexible insurance costs, which have skyrocketed as the insurance companies faced the risk of paying out their guarantees. Having said that, some really novel product has come to market recently, which has led to phenomenal inflow to vehicles like Manulife’s GIF. The big attraction is that the latest generation have very retirement friendly guarantees…for example, many guarantee that the invested principal is the least that can pay out over twenty years of retirement…and some increase the benefit for every year that the principal is left untouched…investors may like to remain in the equity market, but have security of their principal…and older investors may choose these funds as a hedge against inflation, and an estate planning vehicle…as an insurance contract, they may avoid probate fees, and pay out like any other insurance proceeds…again, an advisor is key to avoid any undesired consequences.


Corporate Class Funds

Many major mutual fund companies offer corporate class mutual funds…and these may be attractive to investors who are seeking tax efficient income…the mechanics are a bit beyond what I want to get into today, but because these funds are set up as shares in a corporation, income that might have been traditionally allocated to an investor as interest or dividend income may be converted to capital gains income…which may be taxed at a significantly lower rate…other companies have set up fixed distributions of the invested capital, which reduce further the immediate tax on income…although any tax planning strategy should involve your lawyer and wealth advisor.


Structured Products


In the declining interest rate environment of the last few years, many fund management companies developed so called structured products…the lion’s share of these are issued with a guarantee of principal at maturity, and provide a distribution of income during the life of the product, based on some formula…generally, the coupon was meant to exceed the rate of interest on a bond or GIC…some of these have real merit, but I find they are often highly complex, and the liquidity…the ability to cash them in early…is often at the issuing firm’s discretion…so, at the risk of repetition…work with an advisor on this solution.


Trusts

Almost every solution I have discussed can be held in a trust…so why create a separate category? Trusts are not simple, but with the guiding hand of a lawyer, accountant, trust officer, and advisor, investors with significant assets may find trusts an effective way to grow and distribute wealth, while reducing taxes…I recently hosted two trust specialists on the show, and encourage anyone wanting to know how to integrate a trust into your financial plan to contact me directly, and I will put you in touch with a specialist in this area.


Hedge Funds

The final alternative to mutual funds that I will discuss today is hedge funds…these will be the topic of a future show, as they have garnered massive attention in the media recently. A good hedge fund is designed to move in low correlation to the market…a fancy way of saying that their change in value should bear little resemblance to the movement of the equity or bond market… but some are very costly, and may only provide access to your money a few times per year…there are many strategies, and frequently a good hedge fund is only available to accredited investors, so work with an advisor to select the best solution…


I have given you a lot to think about today…but the key message is this…many advisors hold themselves out as being capable of solving every financial need for a client, yet frequently they offer only mutual fund solutions…which may be very expensive as your investments grow…seek out an advisor with a disciplined process, that can help you select the right solution, beyond mutual funds…not just what they are able to offer.


That brings us to the end of this week’s episode of Beyond Funds Market Weekly…thank you for tuning in…if you have questions or comments, visit www.beyondfunds.ca and email me, or call me, Jeff Wareham, at 519-660-3260.

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