Mutual Funds, Segregated Funds & Exchange Traded Funds

 

Investors can also participate in the various asset classes by purchasing a basket of individual investments through a mutual fund or exchange traded fund (ETF).

Some of these are passive investments, meaning they always hold the same stocks regardless of market conditions. Others are active investments, meaning the manager of the fund is constantly looking to take advantage of opportunities and avoid risk by analyzing the prospects of many different companies.

Mutual Funds

While a great deal of emphasis has been put on index funds and exchange traded funds as a low cost way to achieve diversification, these are typically passive investments. In other words, the individual investments within the funds seldom change.

Actively managed mutual funds, on the other hand, use a combination of fundamental and technical analysis to choose the individual investments for their portfolios.

Active management can add value in market sectors or geographical areas where conditions can change rapidly and portfolios need to be adjusted.

Investing in intermediate sized oil companies, mining companies and technology companies offers great opportunity; however, these sectors require extreme diligence and it is best to have a portfolio manager to monitor their progress.

The same applies to the emerging markets where governments, economies and markets change more quickly than in developed markets. These are high growth areas but they are also areas that shouldn’t be bought and then ignored. It pays to keep a watchful eye for both risks and opportunities.

Similarly, the high yield bond market requires diligence when it comes to monitoring the financial position of the companies issuing the bonds.

And in the bond market, managers must always be on the watch for new opportunities as bonds within their portfolios mature.

Active management can be a benefit in all of these situations.

As with any asset class, investors should use the combination of active management, passive management and individual investments that best suit their particular situation.

Valuation

Over the past few years the result has been a growing level of discontent as many mutual funds have seen large redemptions. The problem hasn’t always been with the mutual funds themselves but with the equity markets. A large percentage of investors choose equity based mutual funds and when the equity markets provide returns near zero over a ten year period, even the best managers won’t be able to generate great returns.

But investors “have heard” that mutual funds are bad investments and “have also heard” that dividend paying stocks are good, so there has been somewhat of an exodus from funds into individual stocks. While these investors have experienced some success, it has little to do with mutual funds being bad investments and individual stocks being good investments.

Mutual funds are not inherently bad investments; it is simply that many were chosen based on their past performance rather than with an eye to the future. As a result, too much emphasis may have been placed on mutual funds in one asset class and too little emphasis placed on investments in others.

Over the past ten years, for example, mutual funds that invested in corporate bonds, real estate investment trusts, and gold bullion have performed extremely well. Equity funds, on the other hand, were deeply disappointing in most cases.

Investors will often still buy mutual funds based on past performance even when the economic conditions of the past look nothing like the current conditions nor are they likely to resemble the economic conditions of the future. Historical performance of mutual funds should only be used to compare their results with those of their peers and not used to project any future performance.

Mutual funds cannot be lumped into one category and evaluated on that basis. Ensure that you are making your judgments on an objective basis. A properly diversified portfolio of mutual funds, taking into consideration the factors previously discussed, can be used to build an excellent portfolio.

In the past, one of the primary uses for mutual funds was to invest in the broad equity markets. With the advent of technology and the introduction of new products such as ETFs, that role has been somewhat diminished but mutual funds are still a very important investment that can contribute to a portfolio. For some, they still represent the most viable investment option.

Despite higher management expense ratios (MERs) than exchange traded funds, mutual funds often represent the best alternative for smaller investors trying to build a balanced portfolio because purchases can be made in small amounts without incurring disproportionately high commissions.

Segregated Funds

The life insurance industry participates in the investment business through their offerings of segregated funds or ‘seg funds’. These investments are similar to mutual funds in that both represent a pool of funds that investors pay into and an independent manager makes the decisions regarding the investments held within the pool. However, seg funds, unlike mutual funds, are overseen by the insurance industry.

One difference between segregated funds and mutual funds is that seg funds offer a small degree of protection against investment loss. Most seg funds will guarantee 75% to 100% of the premiums paid, but there is a catch.

Typically, the investment has to be held for a period of ten years before the guarantee comes into effect. Alternatively, the benefit would also apply on the death of the policy holder.

While this guarantee might provide some level of comfort, you would be hard pressed to find a blue chip equity or balanced mutual fund that was worth less than 75% of its value after holding it for ten years. In some ways, the guarantee is a red herring. For the privilege of guaranteeing a loss of no more than 25% of your portfolio over a minimum holding period of ten years, you would pay an annual management fee that is significantly higher than an equivalent mutual fund.

Those who use seg funds as an investment from which to derive income may lose significant guarantee benefits. In this case you may think you are buying a guarantee but the truth is that the guarantee may be much different from what you think it is. Red flags should go up if your financial advisor glosses over this fact.

The primary benefit to investing in seg funds is related to estate planning issues because you can name a beneficiary for your seg fund investment.

Beneficiaries will usually receive the greater of the guarantee death benefit or the market value of the fund-holder’s share without going through probate.

Before making an investment in a seg fund, ensure that you are aware of all the features, benefits and disadvantages of this choice compared to other investments available.

Exchange Traded Funds

Exchange traded funds or ETFS are similar to mutual funds in that they are a basket of individual investments put together to provide investors with an easy way to diversify. A major difference is that ETFs are bought and sold on stock exchanges such as the TSX, while a mutual fund is purchased from or sold to the mutual fund company that manages that fund.

When you buy or sell units in a mutual fund you don’t know what the price will be. The fund is valued at the end of each day and that is the price you will pay for a purchase or receive for a sale.

ETFs are traded continuously through the course of a trading day and you can set a price at which you are willing to buy or sell. They trade in a similar to manner to individual stocks.

Mutual funds and particularly segregated funds will tend to have a higher management expense ratio (MER) than ETFs.

Exchange traded funds tend to have a lower management expense ratio (MER) than mutual funds; however, in a commission based account, there will be a fee charged when you buy an ETF and another fee charged when you sell it. When comparing mutual funds and ETFs, you have to consider any trading commissions in addition to the MER of each investment.

NEXT: Investment Planning - Asset Allocation

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