Due Diligence of Mutual Funds

Publicly offered mutual funds are required to file a prospectus that provides full, true and plain disclosure.  Most of the time, investors are sent the prospectus by regular mail after purchasing units/shares of a fund.  How many people actually read it?  Most rely on their advisor to summarize the main points of the fund.  It is always possible to get a copy of the prospectus prior to investing.

We understand that most investors do not have the time or interest to read through a lengthy prospectus.  After all, the reason they have hired an advisor is to do that homework for them.  Whether or not you read the prospectus yourself, or rely on your advisor, we recommend that you are comfortable answering the following questions: 1) What are the investment objectives? 2) What is the investment strategy? 3) What are the investment restrictions? 4) Who is the manager? and 5) What are the fees and expenses?

Investment Objectives:  A mutual fund’s investment objectives provide investors with information regarding the funds goals and how it intends to achieve them.  Typical types of objectives are growth (primarily stocks), income (primarily bonds and more recently income trusts) and balanced (combination of stocks and bonds).  The investment objectives may also provide information on the types of investments the fund is allowed or prohibited from holding.  Within these objectives an investor should be able to obtain a feel for the risk/reward nature of the investment.  Most importantly, investors should ensure that the fund being purchased is suitable for their overall portfolio.

Investment Strategy:  The investment strategy or style is important because different management styles tend to perform better in certain markets.  Typical types of styles are value, growth, sector rotation, blend, top-down, bottom-up and combination.  A planned approach may consider a blend of management styles as a component to overall portfolio structure.

Investment Restrictions:  Certain mutual funds provide restrictions on the types of investments.  As an example, Socially Responsible/Ethical Funds may restrict the purchase of certain companies.  Another example of an investment restriction may deal with the minimum investment grade of bonds in an Income Fund.  Many mutual funds may also have clauses such as no one position will exceed 10 per cent weighting within the portfolio.  When purchasing a mutual fund it is also useful to know if there is a mandatory holding period.

The Manager:  One of the most important components to selecting a mutual fund is the portfolio management team.  Most managers provide information to investors regarding their management style and philosophy.  When a member of the management team changes, it is important to assess the experience, style and investment philosophy of the new manager.  A change in management warrants careful consideration and may result in a decision to sell the fund.

Fees and Expenses:  Most prospectuses have a section that is titled “Fees and Expenses” that outlines the initial fees and expenses to set up the fund.  This section will also list the annual fees that are paid to the manager and the ongoing expenses of the fund.  The last part of this section normally outlines the service fees that are paid to the investment firm that has custody of the investment, a portion of which is generally paid to the advisor that works for that firm.  The annual fees and the service fees are commonly referred to as the Management Expense Ratio (MER).

In our next column we will highlight the newest development in the mutual fund industry – F Class Funds.

The Expanding Universe of Mutual Funds

After record sales of mutual funds this past year, and with more than 6000 varieties available to Canadian investors, it’s timely to discuss the role that mutual funds play in portfolios today.

Franklin Templeton introduced the first mutual fund to Canadian investors in 1954 with their Templeton Growth Fund, still in existence today.  Until the 1980’s monitoring the mutual fund universe was less complicated.  Since then the retail investor has been bombarded with an exponential increase in mutual fund products and their ever-changing mandates.

The original purpose of a mutual fund was to allow investors to pool money to obtain diversification through one investment company that invested in stocks or bonds.  The pooling of the investor’s funds provided some efficiency along with having experienced management.

The mutual fund universe is a bit of a minefield.  Paying attention to the following points should assist you in avoiding common pitfalls.

Past Performance May Not Be Repeated

Quite often, investors are attracted to mutual funds based on performance alone.  Purchasing last year’s star performer is often a mistake.  Although it is important to look at past track records, investors need to be very skeptical about short-term returns, such as three, six or twelve months.  How has the fund done over three years or over five years?  Have there been any changes in the management of the fund?  How is the fund performing against its peer group?

Avoid Chasing the Flavour of the Month

It seems that many fund companies provide to the market exactly what investors are wanting.  In the late nineties investors wanted technology funds.  Some investors abandoned their plans and purchased funds whose mandate was to hold technology stocks.  These same investors, often over-weighted in the latest flavour, saw their fund values decline significantly when the tech bubble burst.  A key point to highlight here is that a sector fund should reflect the investor’s investment objectives and risk tolerance.

Selling Based on Poor Performance

It may sound counter-intuitive to think that a well-constructed portfolio should generally have some investments that are not performing as well as others.  Different types of investments will have different returns in different markets.  Before selling that under-performing fund we recommend that you first compare its performance next to its peers and its relative benchmark.  It is quite possible that the fund is complementing your portfolio but will only show its true colors in a different market.  If a fund has under-performed its benchmark and its peers then by all means it may be time to look at a change.

The Merits of Disciplined Management

Investing in a mutual fund means you are pooling your money with other investors and having a manager do a certain job investing it on your behalf.  In doing so, they can make hundreds of transactions and changes a year.  Buying a fund because it has some large weighting in a company you like isn’t a well-thought out idea.  If it hasn’t changed by the time you bought the fund, it could change very shortly thereafter.

Prior to purchasing any investment it is important that the investment is suitable for your overall portfolio strategy.  Your investment advisor should be equipped with the necessary programs to evaluate your mutual fund holdings.  Our next column will provide some tips on items you should look at when selecting mutual funds.

Building plan keeps investors on track

Imagine building a house without a set of plans.  How would that house look if you randomly selected flooring, furniture and window coverings without regard to how they would look together?  It certainly can be done, but we all know that when building or decorating a home, it is best to follow a plan.  Once a plan is put in place, the results can be spectacular!

Too often investors select investments without consideration given to the other investments within their portfolio.  Does purchasing that one additional investment increase or reduce the risk to the investment portfolio?  Does it increase the return potential or reduce it?  Does it compliment the other investments?

The financial equivalent to a blueprint for building a home is an Investment Policy Statement (IPS).  Ideally an IPS should be laid out in advance of the portfolio’s construction, however, an IPS can be done at any time – call it a renovation if done after the fact.  Developing an IPS normally begins with the investment advisor asking their client to answer a series of questions.  The investment advisor should review the answers to these questions with the investor and clarify any inconsistencies.  The responses to these questions, along with notes made during preliminary discussions, are the foundation to an IPS.

An IPS is part of a disciplined approach that attempts to remove some of the “emotional component” of investing.  Uncertainty about the markets, fear of losing your money, and confusion as to what is the best course of action during volatile market times can cause investors to abandon the plan.  Sticking to the IPS during difficult times is a critical part.  As we all know, we cannot individually control the market, however, we can control how we react to it. An IPS can help manage those bumpy times.

An important component of those discussions should focus on risk tolerance.  The easiest way to look at risk tolerance is by the percentage of equities in the account.  An investor who is risk averse would have a lower percentage of equities.   Investors that do not want to incur risk should have a larger component of investments such as GICs, treasury bills, and investment grade bonds (often referred to as fixed income).   As fixed income investments are not as volatile as equities, they are a key component for those seeking low risk investments and have capital preservation as a primary investment objective.  Most investors desire total returns greater than those currently offered by fixed income.  As a result, risk tolerant investors are willing to hold some component of equities.

As every investor reacts differently to volatility, it is finding that balance (also known as Asset Mix) that the investor is comfortable with.  Investors that do not assume some risk may feel they are missing out on potential opportunities, and investors that feel they are taking on too much risk may be continually worrying about their investments.

So, what are the typical characteristics of the risk-tolerant and risk-averse investor?  Typical characteristics of risk-tolerant investors are:  longer time horizon, high annual income, high net-worth, and multiple sources of income.   The typical investor who is risk-averse, would have the following characteristics:  shorter time horizon, no longer in the work force/approaching retirement, fixed income, low to moderate net-worth, and limited sources of income.

The above general rules certainly do not apply to everyone, this is the reason a customized IPS is necessary for each investor.  The most risk-tolerant investor may intentionally overweight equities while the most risk-averse investor may deliberately select mainly fixed income.  However, most investors fall somewhere in between.

Determining the balance of cash, fixed income and equities is ultimately the decision of the investor.  An advisor has several tools in which to assist their client in making this decision.  An IPS is not set in stone – changes may occur with time, life changing events and investment experience.  Some advisors may recommend increasing or decreasing the fixed income component during certain economic cycles.

One rule of thumb that is used by some investment advisors is that the fixed income component should be reflective of your age.  A 20 year-old investor should have 20% fixed income where an 80 year-old investor should have 80% fixed income.   This method of determining the asset mix is overly simplistic but it does illustrate the trend of having a larger fixed income component as an investor gets older.

As it takes time to build a house, it takes time and patience to build an investment portfolio.  Once built it still requires maintenance.  The IPS is a plan, not an immediate reflection of how the portfolio will look on day one.

After reading this article, we hope investors will try to locate their written Investment Policy Statement.  If they have one, they should ensure they are using it and that it is up to date.  If they do not have one then statistics state they are among the majority of investors without a plan.  We also hope those investors without an IPS will meet with their investment advisor to discuss the benefits of an Investment Policy Statement.

A penny for your thoughts

So you want to invest? You’ve got a variety of options but your final decision will depend on your ultimate goals

There are as many different goals, incentives and philosophies behind investment decisions as there are investors.   One person we know always seems to get annoyed with accumulating pennies – he does not feel that accumulating these in his pockets will amount to anything of substantial value.  In fact, he regularly throws them into the garbage, as he doesn’t feel they are worth the time it takes to roll them up and deposit them.  On the other end of the spectrum there are some individuals that will stop to pick up those pennies!  Call it being thrifty or having grown up in more difficult times but they understand that “crumbs make bread!”

Most people try to be thrifty with their money, and investors are concerned about how their financial advisor should be paid.  Most investors would agree that the real issue is not how much compensation should be paid to their financial advisor, but rather, is there a sufficient return on their investment.  In other words, compensation, or price, is only an issue in the absence of value.

What should financial advisors get paid?  Maybe a better question is, how should they be compensated? So when an investor meets with his or her financial advisor for the first time, there should be a clear understanding of expectations, including compensation to be paid to the financial advisor.  To answer these questions we need to look at the different types of investment accounts, as each type dictates a different method of compensation payable to the financial advisor.

If we unbundled all the financial terminology and the fancy product names we can break it down to five main types of investment accounts.  The five options are:

  • Bank / Credit Union
  • Discount Brokerage
  • Managed Accounts
  • Transactional Accounts
  • Fee-Based Accounts

There is no single option that is better or worse as the individual needs of an investor should be the guide in selecting the most suitable option

Do people still keep their money under their mattress?

Occasionally we hear of individuals who still follow this practice.  But we hope most people have confidence to trust the chartered banks and credit unions.  Local bank and credit union branches have qualified staff to not only discuss your day-to-day banking and borrowing needs but can also assist with explaining the available investment products available at their financial institution

Everyone likes a discount

Many firms have set up a separate business unit designed for individuals that would like to do trading themselves.  Discount brokerages often advertise their trading fees such as $9.95 trades or $29.95 trades.  Incentives may be offered to investors by offering a limited number of free trades for signing up for discount brokerage.  For regulatory purposes, investors of discount brokerage are not provided with advice or recommendations. The investor alone is responsible for his or her own investment decisions and whether those decisions are suitable.  So who should consider discount brokerage?  They should be investors with medium to high investment knowledge who want to research investments themselves or do frequent unsolicited trading.  They should also have the time to fill orders via phone or computer.

Even the person that throws away his pennies appreciates a good discount.  But, remember, like most things in life – you get what you pay for.

What are managed accounts?

Essentially, this is a customized mutual fund.  With this type of account, the investor is giving an external investment company (and not the financial advisor) the authority to manage their account.  This does not mean that the financial advisor is “off the hook.”  The advisor has four primary responsibilities:

  1. To understand the needs of the client:  the advisor has the responsibility to know the investor and determine if a managed account is appropriate.
  2. Manager selection:  external managers generally provide advisors information on their process and features of the managed account.
  3. Assisting the investor with the “customized” component:  typical types of customization are by region, asset mix and asset type).  For example, an investor may choose the following – Region: 70 per cent Canada, 10 percent United States, 10 per cent international and 10 per cent global; Asset mix: 10 per cent cash, 65 per cent equities, and 25 per cent fixed income; Asset type:  70 per cent large cap, 15 per cent medium cap, and 15 per cent small cap.
  4. Ongoing monitoring:  the advisor should monitor the performance of the manager (next to appropriate benchmarks) and explain the results to the investor.  Changes might be in order when appropriate and as agreed upon with the investor.

So, who should consider a managed account?  Investors who prefer not to be contacted regarding individual equity and fixed income trades, or those who travel frequently or prefer access to institutional style managers.

Are transaction accounts my best option?

Transactional accounts have been around since the full-service brokerage began.  Similar to discount brokerage a commission is charged with every purchase and every disposition.  The commission amount may fluctuate with full-service depending on the financial advisor’s pricing methodology.  The total value of the trade is generally the biggest factor, along with the number of shares and price per share.

A transaction account may be a good option for you, if you fit the following criteria::

  • Investors with investment assets under $150,000
  • Investors that prefer to buy and hold investments, so that little trading is done
  • Investors with a long term time horizon
  • Investors wanting access to research publications
  • Investors not requiring frequent withdrawals from the account
  • Investors that already have accounts set up in good order
  • Investors that are paying little or no income tax
  • Investors seeking infrequent investment advice

What is a Fee-Based Account?

This type of account charges an annual fee based upon a percentage of the total household assets under advisement.  This fee is assessed quarterly, based on the average total household account balance.  The fee usually allows a specific amount of free fixed income and equity trades and some firms offer unlimited mutual fund trades.

Advisors are not compensated per trade so each buy and sell decision is based on the investor’s strategic needs.  Commission and trading costs are not an issue.  In a fee-based environment, investors are reassured that decisions are driven solely by investment objectives.   If an investor’s account increases in value so does the compensation to the advisor.   Conversely, if an investor’s account declines in value, so do the fees paid to the advisor.  With this structure, the advisor has a direct incentive to work on having your account increase in value.  This should remove any perceived conflict of interest – advisors and clients are on the same side of the table with a fee-based account.

Who should consider a fee-based account?

  • Investors seeking ongoing objective advice
  • Investors with investment assets of $150,000 or greater
  • Investors wanting to eliminate annual administration fees and trading commissions
  • Investors wanting mutual funds purchased without front end or back end load fees
  • Investors interested in F-class mutual funds
  • Investors wanting access to research publication
  • Investors that are able to fully deduct investment council fees for non-registered accounts and this deduction can be claimed immediately (in the year paid)
  • Investors wanting to take advantage of ongoing total financial solutions (assessment of the investors borrowing & banking needs, tax planning, protection strategies, financial planning, retirement planning, estate planning, etc.)

The Jones Went Fee-Based All the Way!

After discussing the types of investment accounts with Mr. And Mrs. Jones, they chose a fee-based account because it was right for them – it was a natural fit.   The estimated annual fee of 1.25% or $3,125 ($250,000 * 1.25 per cent) is deductible in the year paid.  Assuming a 43.7 per cent marginal tax rate, the Jones would include $3,125 on schedule 4 which would result in tax savings of approximately $1,366 per year.  Factoring in the tax refund, the net fee amount of $1,759 represents an annual fee of approximate 0.7 per cent.

The primary reasons the Joneses decided on a fee-based account were:

  1.  Transparency – The Joneses are fully aware of the fees charged to manage their portfolio and they understand how their advisor is paid
  2.  Going fee-based ensures the Joneses and their advisor are aligned
  3.  Fees are tax deductible

We acknowledge that every investor has different needs, means, and goals.  Charging a fee or flat percentage has grown in popularity over the past several years.  While it may not be right for everyone, a fee-based account can be a very shrewd decision for investors such as the Jones.

Riding out of a perfect financial storm

October can be a scary time – especially when it comes to stock markets and money.  Historically, the month of changing leaves, carved pumpkins and Halloween has not always treated investors with sweet rewards.

In fact, this past October represented the third-worst point decline in the TSX Composite Index over the past 30 years.  Only the Octobers of 1987 and 2000 were worse.  Black Tuesday – October 29, 1929 – remains one of the scariest days in market history.  Black Monday, the worst one-day decline the world has ever known, is more recent, occurring on October 19, 1987.  Even more recent has been the decline in the Nasdaq Composite, largely comprised of dot-com and technology stocks.  During a painful, 19-month decline the Nasdaq fell 78 per cent off its high of 5,046.86 to 1,114.11 on October 9, 2002.

Did We Have Any Warning?

The crash in October 29, 1929 had some warning signs.  Increased volatility earlier in the year, economic indicators pointed towards a slowdown in May and June, and export earnings had declined – all giving an indication that the economy could be heading towards a recession.  It all led to the Great Depression.  The crash on 1987 caught investors more by surprise.  Most investors who stayed the course saw the value of their portfolio come back to pre-crash values in relatively short order.

Crash vs Healthy Correction

Nothing goes up forever.  After a strong performance over the beginning part of this year, it was reasonable to expect some sort of pullback at some stage.  These pullbacks are, for the most part, viewed as a healthy component to the stock market.  Crashes are few and far between.  Certainly extended bear markets can give the same end result of a crash, the difference being that they provide more time for decision making.

The Perfect Storm

October 2005 shouldn’t be a complete surprise.  As we approached this October we were in many ways entering the perfect storm – inflation concerns increasing, interest rates rising, Canadian dollar trading in high range against the U.S. dollar, an unusually strong summer, rising energy costs, decreased corporate earnings forecasts, and continued uncertainty regarding the taxation of trusts.  Not to mention the natural storms/disasters that have occurred in recent months and concerns over the avian flu.  It was reasonable to expect a healthy correction was coming.

The Skinny on Income Trusts

The markets had some pretty drastic declines this past October, which especially impacted income trusts.  The tax-efficient equity investments generally offer a higher yield (monthly distribution) to unitholders than the average common stock (dividends).  The main attraction of holding income trusts is to receive the regular cash distribution payment that in many cases is treated favourable for tax purposes.

The ability for the trust to pay out distributions on a sustainable basis is a function of the success of its underlying business.  Income trusts are more similar to common stocks than fixed income securities as there are no guarantees surrounding the distribution or the principal, nor are there set maturity dates.  There is a wide variety of underlying businesses that income trusts are based upon including power distribution facilities, real estate properties, pipelines, restaurants, advertising and resource-based operations.

The primary benefit of investing in income trusts is the ability to fulfill income objectives. The majority of investment returns tend to be generated by the distribution stream while total returns may be enhanced or hindered by capital appreciation or depreciation of unit prices.  Over the past few years in an environment of declining interest rates and equity market volatility, there has been strong investor demand for investment income, which has led to higher income trust prices.

Some of the risks associated with investing in income trusts:

  • The viability of the business to continue operations.  On September 26, 2005 the CFO of Heating Oil Partners Income Fund issued a press release announcing the Chapter 11 filing.  In this press release, they cautioned that it is unlikely that unitholders will receive any consideration after the restructuring.
  • Distribution levels are not guaranteed.  On October 18, 2005, a press release from Clearwater Seafoods Income Fund announced a reduction in annualized distributions for 2005, suspending monthly cash distributions for the remainder of the year.  Clearwater’s unit price was punished severely immediately following this release.
  • Unit price volatility primarily due do changes in supply and demand and the relative illiquidity of certain income trusts.
  • Income trusts are interest sensitive.  Changes in the level of interest rates can have a significant effect on trust units.  As interest rates increase the demand for income trusts should decline as investors can obtain yield elsewhere.
  • Currency risk for those income trusts operating south of the border.
  • Uncertainty regarding Government policy on trust taxation.

We believe that the relative weakness in business trusts can be attributed primarily to the uncertainty regarding possible changes in the Ottawa’s policy on trust taxation, as well as increased concern about higher interest rates. The lack of trading volume of some trusts may also result in greater price volatility.  Some of this uncertainty should be reduced after the Ottawa releases the results of the consultation process which is expected to be completed by December 30, 2005.  The government also announced at the end of September that it will immediately postpone providing advance income tax rulings on flow-through entities (income trusts and limited partnerships) until the consultation process is complete.

Where Is The Treat This October?

As with everything in life, it’s how you look at things.  A healthy correction can be a treat.  Unless you need the cash in the near term, these pullbacks or “healthy corrections” can be a positive thing, especially if you have cash on the sidelines.  If you have cash, this is likely what you were anticipating may happen.  Unfortunately, stocks seem to be the one thing that investors are reluctant to purchase when they go on sale.  For investors with a long-term time horizon, greater than 10 years, look at the pullback as a part of equity investing and a positive opportunity.  Signs of slowing economic growth, rising inflation, rising Bank of Canada overnight lending rates, rising long-term bond yields, as well as uncertainty regarding the taxation of income trusts suggests that the market trajectory remains downwards for the remainder of 2005 in our opinion.  This is a good time to look at asset allocation, clean up the weaker names, focus on quality and value.

Keeping up with the Joneses

The Greenard Index is a new investment column based on the Jones Family, a professional couple with a joint investment portfolio of $250,000.

Profile of The Jones Family

Join us as we track the investments of Jack and Jill Jones, aged 48 and 45 respectively.  Jack owns and manages his own business.  Jill is employed by the provincial government and is a member of the pension plan.   Jill’s income is relatively stable and known.  Jack’s income level fluctuates and in good years, he has a significantly higher income.  Jack and Jill have three children aged 16, 12 and 6.  Both of Jack’s parents are in good health and are aged 70 and 68.  Jill’s father passed away some years ago, her mother is 83 years old and in poor health.

Going forward we will be discussing market events, investment ideas and other relevant topics that impact the Joneses in taking care of their investments.

The decision to maintain a large component of cash equivalents is a deliberate one at this time.  After the original deposit we recommended that the Joneses purchase the Altamira High-Interest CashPerformer for their portfolio.  The CashPerformer is considered “cash equivalent” as it is low risk and liquid.

The CashPerformer is also a safe place to park cash while the Joneses patiently ease into the market.  Interest is calculated daily on the CashPerformer which provides the Jones with the flexibility of adding to the position throughout the month and not being penalized by early withdrawals.   The CashPerformer is currently earning 2.5% which is competitive when compared with other high interest savings options.