New disclosure rules on adviser’s fees could reduce ranks

Over the next few years, you are likely to hear more about what is referred to as the “client relationship model,” or CRM.  CRM is a regulatory requirement introduced by the Canadian Securities Administrators to enhance disclosure, which partially came into effect this year.  Further phases over the next three years are intended to enhance the standards financial firms and advisors must meet when dealing with clients.  These amended rules provide greater disclosure requirements for advisors and enhance the standards they must meet when assessing the suitability of investments for their clients.

The key objective is increased transparency for investors surrounding the fees they pay, services they receive, potential conflicts of interest and the performance of their accounts

All of these mandatory disclosures will be phased in from 2014 – 2016.   Similar CRM mandatory disclosure rules were implemented in Australia and England.  The implementation of the changes in those countries resulted in a significant reduction in the number of financial advisors working in the industry once rules required them to be transparent about all the fees charged.  I suspect that once the new rules are fully implemented, there will also be a reduction in advisors working in Canada.    

To help illustrate how these changes may affect you, let’s look at GICs and mutual funds.

Many people may be aware that when a financial institution receives investments from people, they then lend that money to other people at a higher rate, simply acting as an intermediary for profit. What most people likely do not know is that every time you invest in a GIC, the financial institution makes a spread, or simply put, a profit. 

Depending on the rates of the day and the length of the term that profit could be range from 10 to 25 basis points per year invested.  The range of the fees could be as low as 0.10 per cent for a one year GIC to 1.25 per cent for a five year GIC.   So on a $100,000 GIC for 5 years, your local financial institution might make between $500 (low end) and $1,250 (high end).  One percent equals 100 basis points in financial lingo.  Low-end is calculated 10 basis points x five years x $100,000.  High-end is calculated 25 basis points x five years x $100,000.  Starting this coming July, all financial institutions will have to disclose this to everyone. 

Let’s move to mutual funds. Take that same $100,000 and assume that you invest it into a balanced mutual fund. There are three potential ways the advisor could get compensated for their advice.  They could charge a fee initially, between one and five percent – referred to as Front End (FE). 

Front End is sometimes referred to as Initial Service Charge (ISC).  Some advisors have adapted a structure similar to banks and don’t charge a Front End fee.  Other advisors could do a Deferred Sales Charge Fee (DSC), where the client pays nothing initially but the advisor collects around five per cent immediately, so in this case, $5,000 from the mutual fund company because you are now committed to that fund family for six or seven years.

The fees to redeem the DSC mutual fund in the first couple of years may be approximately five per cent, and declining over a six or seven year period at which point the fund can be sold for no DSC costs.

There is also a variation called Low Load (LL) which is simply a form of DSC. If you see DSC on your statements, you know you are locked in.   Then inside, embedded in every mutual fund is an ongoing management fee.  As an example, a typical Canadian equity fund may have a 2.5 per cent embedded annual fee that is divided up amongst the advisor every year along with the mutual fund manager and their company.   These combined fees are often referred to as the Management Expense Ratio (MER).  I have found that the MER is rarely disclosed and, with the new rules, it will have to be.

It is very likely that many investors do not know how their advisor makes money or what fees they really are paying.  Knowledgeable and professional investment advisors, just like a good accountant, deserve to charge a reasonable fee for their service. But unlike accountants who send you a bill, investment advisors can currently sell you a product and not tell you what they just made.

More advisors are moving to a fee-based approach which is transparent and, in many cases, tax deductible. There is so much more to come that it may be a good idea to start asking questions now. The next time your banker or your advisor speaks to you about a new investment, consider asking for a complete breakdown of what fees you are paying going in to the investment, what the advisor is getting paid, if any fees apply to sell the investment, and what your fees will be each year thereafter for the advisor to manage your affairs. 

Advisors that have always provided complete transparency to their clients will not need to make any changes in the way they communicate with their clients. In fact, they may end up benefiting from the CRM changes. 

Control investment costs, increase your net return

Many people don’t pay too much attention to the costs associated with investing. If we look at both your returns and cost of investing, we can create what is called your net return.  Your net return can potentially increase by either improving your return, or lowering your cost of investing.

To illustrate we will use Mr. Lee, a 55 year old investor who has $500,000 in an RRSP account.  Mr. Lee has explored the following four options with various costs of investing (increasing at one per cent increments with each option) and service levels:

Option 1:  Self managing investments through Exchange Traded Funds (ETFs) – often referred to as couch potato investing.  With this approach, you receive no planning or investment advice.  This approach is passive as it holds the investments that are in the respective index and are not actively managed.  The annual cost of investing for this option can be around 0.5 per cent, or $2,500 in the first year.

Option 2:  Working with an advisor owning direct holdings in a fee based account.  The fees for this option can fluctuate depending on the advisor and the amount invested.  The fee often decreases as the account value increases.   The benefit of this option is that an advisor is able to assist you with both planning and your investments.  Option 2 is the most transparent with respect to fee disclosure of all options.  If Mr. Lee put the $500,000 into a balanced portfolio, it would typically be priced at 1.25 to 1.5 per cent.  For our example we will use 1.5 per cent, or $7,500 in the first year.  It is important to note that a good advisor is well worth the additional fee over the ETF approach.

Option 3:  Purchasing mutual funds is another commonly used investment approach.  Mutual funds are actively managed by a portfolio manager that has a specific skill set in the fund(s) that you’re buying.  Mutual funds have embedded annual fees called a Management Expense Ratio (MER).  In addition to the MER, funds may be sold on a front end basis with addition fees of up to 5 per cent initially, or sold on a back end basis where you are typically not charged a fee initially but would be charged a fee if you sell the fund within the applicable Deferred Sales Charge (DSC) period, often seven years.  The fee may be as high as 6 per cent initially if sold in the first year, and declining every year until the DSC schedules is complete. An advisor selling funds may look at Mr. Lee and think his time horizon is ten years and that he may be invested in the funds through the DSC schedule.  If Mr. Lee is sold funds on a back end basis where DSC may apply, he is somewhat squeezed into a corner if he is not happy with his performance, or would like to make a change within the DSC period.  For purposes of this illustration we will assume that the only fees Mr. Lee pays is the 2.5 per cent annual MER, or $12,500.

Option 4:  Mr. Lee has heard about some guaranteed insurance products called segregated funds.   The primary difference between mutual funds and segregated funds is that the later is an insurance product.  Being an insurance product, the investments can be set up with different maturity and death benefit guarantees.  Another feature is segregated funds have the ability to name beneficiaries to bypass probate and public record.  In the case of Mr. Lee the funds he has are registered.  With registered accounts it is not necessary to purchase an insurance product to get this benefit as he already has the ability to name a beneficiary, his spouse, which also will assist them in avoiding probate on the first passing.  There is a cost to have the insurance benefit noted above. For illustration purposes we will assume the annual MER for a basket of segregated funds is 3.5 per cent, or $17,500 annually.

The long term effect on accumulated savings can be quite shocking when different net returns are explored over a ten year period.  To help with the illustration, we will make the assumption that investment returns over the next ten years will be six per cent for all four options.

Option 1:  ETF approach – net return is 5.5 per cent (6.0 per cent less the 0.5 per cent fee). A net return of 5.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $854,072 at the beginning of retirement.  He would have been responsible for all of his choices of ETFs and have no planning advice.  Although costs are low with option 1, there is a high degree of involvement to determine timing of when to buy the ETF and which ones to buy.

Option 2:  Direct Holdings in Fee-Based Account – net return is 4.5 per cent (6.0 per cent less the 1.5 per cent fee). A net return of 4.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $776,485 at the beginning of retirement.  The additional cost of investing over option 1 would more than likely be offset by higher returns with a good advisor.  A knowledgeable advisor is also able to provide you financial planning tips, and service that enables you to do other things in retirement.

Option 3:  Holding a Basket of Mutual Funds – net return is 3.5 per cent (6.0 per cent less the 2.5 per cent fee). A net return of 3.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $705,299 at the beginning of retirement.

Option 4:  Holding a Basket of Segregated Funds – net return is 2.5 per cent (6.0 per cent less 3.5 per cent fee). A net return of 2.5 per cent compounded over ten years would have grown Mr. Lee’s $500,000 RRSP to $640,042 at the beginning of retirement.

The above illustrates a one per cent change in the cost of investing for each option – it clearly shows how these small changes can have a material impact on your long term financial success.  The same exercise can be done assuming different percentage returns (i.e. four, five, six, and seven).

Fixed-income investments simplified

To diversify your investments you should have a fixed-income component in your portfolio, such as guaranteed investment certificates or bonds.

But you should have an understanding of the different ways of holding fixed income investments and the underlying risk of each option.

Term deposits and guaranteed investment certificates are a common way to hold fixed income.  The return is known and all fees are built into the initial sell price.  If you purchase a one-year $100,000 GIC at 4.5 per cent then you can count on receiving $4,500 and your original capital back in one year.  This certainty comforts a lot of people and the investment is easy to understand.  It is also easy to plan your cash flows.

Holding federal and provincial government bonds are generally considered low risk.  In recent years, GIC returns have often exceeded the returns offered by low risk government bonds.  Investment grade corporate bonds can be another way to purchase fixed income.  The return potential on corporate bonds generally exceeds government bonds and GICs but the risk element increases.

Another common form of fixed income investment is a bond mutual fund or a balanced mutual fund.  A bond mutual fund invests in a basket of fixed income investments.  Depending on the fund prospectus, the mandate can result in significantly different structures between funds.  Not all bond funds are created equal.  Some bond funds are very conservative while others may take on considerable risk.

Conservative bond funds may hold government bonds and investment grade (BBB rating or better) corporate bonds.  Treasury bills, banker’s acceptances, and term deposits are all considered low risk and are common in conservative bond funds.  One of the benefits of holding bond funds is the ability to diversify your fixed income.  Diversification of fixed income can be done through holding different types (issuers), qualities (credit ratings), and maturities (mixture of short, medium, and long term).

The added “diversification” benefit of bond funds comes at a cost often referred to as a management expense ratio (MER).  Regardless of where interest rates are at, it is important to ensure you are not paying an excessive amount to manage your money.

As an example, let’s use a typical bond fund with an MER of 1.5 per cent.  Let’s also assume that GIC rates are currently 4.5 per cent.  Individuals choosing the bond fund option should feel comfortable that the manager can put at least 4.5 per cent in your pocket.  With an MER of 1.5 per cent, the manager of this bond fund will have to take on some risk to earn 6.0 per cent or more. Your return is not guaranteed with bond funds and can be negative.

Riskier bond funds do exist and have very different mandates than the typical conservative bond fund.  Bond funds that hold non-investment grade bonds, also known as high-yield or junk bonds, may certainly have the potential to earn 6.0 per cent or more.  They also have a much higher degree of risk and generally have a higher MER.  Other funds may hold foreign bonds or concentrate in certain countries such as the United States.

We caution investors to understand currency risk before investing in foreign bonds.  For investors with a large portfolio, foreign bonds may provide some additional diversification.  Some bond funds have a small equity component, generally with dividend paying investments such as common shares.  If a fund holds a significant equity component then it is often referred to as a balanced mutual fund (holding a balance of equities and fixed income).

We encourage most investors to keep things simple.  Establish an asset mix and determine the percentage of fixed income that is suitable for your individual risk tolerance. Once the fixed income component is established we recommend most investors stick to lower risk and investment grade options.

Hedge funds appeal to sophisticated investors

Hedge funds have traditionally been available only to sophisticated, high net worth individuals.  But some companies are creating hedge-related products marketed to a wider range of investors.

What is a Hedge Fund?

The original hedge fund strategy involved two parts – long and short.  The first part involved investing in individual equity positions that the manager thought would increase in value (also known as holding the stock “long”).  The second part of the strategy involved the manager selling other positions “short.”  When a manager sells a position short they believe the position will decrease in value.  The term “short selling” is key to understanding the origin of hedge funds.

Today hedge funds employ various investment strategies, all quite different from one another. What they share in common is that they are actively managed investment funds with absolute return objectives. Performance-based compensation and the ability to use leverage are also typical characteristics of hedge funds.

Hedge funds are often broadly classified as “alternative strategies,” the following are some of their strategies:

  • Long/Short Equities
  • Equity Market Neutral
  • Dedicated Short Bias
  • Emerging Markets
  • Event Driven (also known as special situations)
  • Fixed Income Arbitrage
  • Global Macro
  • Convertible Arbitrage
  • Managed Futures

Mutual fund companies and small boutiques are among the participants making hedge funds available.  Most of the generally available funds are sold as private placements with high minimum investments and most are of the long/short or equity market neutral variety.  Minimum investments, for those offered by private placement, vary by both issuer and province.  Some hedge funds have included certain limitations to make themselves acceptable for prospectus offerings, allowing minimums as low as $5,000.  Other hedge funds are priced exclusively for the ultra-affluent market with minimums running in the millions of dollars.

Despite the low minimums indicated above, they are not for everyone.  They may not be suitable for investors with total equity investments less than $250,000.  Hedge funds are primarily designed for sophisticated investors and carry with them significant risks that are different from other funds.  Similar to traditional long-only mutual funds, there are only a handful of managers and funds that are worthy of an investment.

The starting point for investors wanting to look at hedge funds is ensuring that they are considered within the context of a well-diversified portfolio and personal risk tolerance.  Certain hedge funds can be useful for providing additional portfolio diversification.   Hedge funds tend to move with a lower correlation to traditional equity markets.

Sophisticated investors with an equity component greater than $250,000 may want to know how much of a portfolio is appropriate to allocate to alternative strategies.  Provided the sophisticated investor also has a high tolerance for risk, five to ten per cent of their equity component is a reasonable allocation.

Hedge funds have been somewhat less than fully transparent from a reporting perspective.  As a result, people should obtain a detailed understanding of a fund’s manager, their strategy, and fee structure.  Most hedge funds have two components to their fee structure, the management fee and performance fee.  Management fees may typically run between one and four per cent a year.  Typical annual performance fees are between 10 and 20 per cent of the total return of the fund.  Management fees and performance fees vary from fund to fund.

For investors wanting to invest in hedge funds, we recommend doing your research.  The first thing you may come to realize is that certain strategies carry higher levels of potential risk than others.  Experienced investors ensure they obtain an understanding of the potential risk and return characteristics of the strategy itself.

Risk is not necessarily what has happened in the past but what could happen in the future.   Beyond the strategy itself, it is important to review the credibility and experience of the manager.

Here are some important questions to ask prior to investing in a hedge fund o ask prior to:

  • What is the investment training and background of the manager and their team?
  • Are the managers investing some of their own assets in the fund?
  • Have the managers ever run a hedge fund before?
  • What is the hedge fund’s strategy?
  • How does the strategy work, and what are the parameters or guidelines outlining what the manager can or cannot do to implement the strategy?  What is the extent of leverage, position sizes, etc.?
  • What is the level and consistency of reporting results? Are explanations of those results supplied?
  • What are the fund’s risk management and compliance procedures? Are they effective?
  • How liquid is the hedge fund? (this should be consistent with your time horizon)
  • What are the fees to sell?
  • What are the management and performance fees of the hedge fund?

The number of structured products and alternative strategies, like hedge funds, are continuously growing.  Hedge funds are also becoming more accessible.  There are major variations in the quality, structure, strategy and risk of hedge funds.  We strongly recommend that people be very careful prior to investing in hedge funds.

Closed-end funds grow popular

Funds allow investors the ability to obtain diversification by pooling their dollars together.  Investors must be careful to pick the fund managers they feel will do the best job.  With the number of funds steadily increasing this is not an easy task.  In addition, there are a variety of different funds available with different investment objectives, strategies, and portfolios.

The purpose of this column is to discuss investment strategies with respect to “closed-end” funds.  It is important for investors interested in funds to obtain an understanding of the difference between “closed-end” and “open-end” funds.

Open-End Funds

Most of the funds on the market place are open-end funds (OEF), which generally have no restrictions on the amount of shares the fund will issue (unless a fund manager closes the fund to new purchases). The fund will continuously issue shares and also buy back shares when investors wish to sell.  OEFs are issued by an investment company, and are subject to certain disclosure rules.  After purchasing an OEF you will generally receive a full prospectus in the mail outlining the funds investment objectives, strategies and fees.

Closed-End Funds

Growing rapidly in the market place are closed-end funds (CEF).  The initial public offering is generally done through a prospectus, similar to OEF.  This document is intended to provide investors complete information on the structure as well as all applicable fees.  We encourage investors to read this document.  As an example, the prospectus may specifically state whether the CEF may use leverage within the structure.

Important Difference

CEFs do not continuously offer their units for sale as an OEF would.  CEFs sell a fixed number of units at one time, through the initial offering.  After the initial offering the shares typically trade on a secondary market, such as the Toronto Stock Exchange (TSX).  CEFs trade on an exchange much the same way as individual equities.

Net Asset Value

OEFs are bought and sold at net asset value (NAV) directly from the fund company.  NAV is the total value of the fund’s portfolio less liabilities generally calculated on a daily basis.  As noted above CEFs trade on an exchange after the initial public offering.  As a result, they are generally bought or sold at a discount or premium to its NAV.  Although a fund company does not redeem CEF units, most disclose their NAV daily.

Discount

When CEFs disclose their NAV, these may be compared to the most recent trades in the secondary market.  Investors who look at the various CEFs offered in the secondary market may find that most trade at a discount to their NAV.  It is not uncommon to see some CEFs trading at a discount of 5 to 10 per cent or more during market volatility.  This may be a little frustrating for investors who purchased a CEF at the initial issue and are now looking at selling their units.  On the flip side, opportunities may become available for investors looking on the exchange for deep discounts (large differences between NAV and market value).

Liquidity

Some CEF investments are not redeemable for a period of time.  CEFs are generally structured so they are not required to buy units back from investors until maturity of the structure.  CEFs therefore may not be suitable for individuals who desire liquid investments.  CEFs are generally not redeemable by the company (see redemption privileges below).   Investors should use caution prior to selling CEFs on the secondary market.  Many CEFs have very little trading volume and care should be taken before entering “market” orders.  Prior to making a CEF purchase on the secondary market, investors may be able to look at the historical volumes and total issue size of the CEF.  This may provide some indication as to the future liquidity.

Volatility

As noted above, the trading volumes on CEFs may be very low.  In some cases the spread between the bid and the ask may be significant.   Once a secondary market exists for a CEF, investors are able to sell their units if there are buyers.  It is not uncommon to see a significant change in the market price of a CEF when an investor sells a large position.

Redemption Privilege

One feature that investors should consider prior to purchasing a CEF is if the offering document provides for a redemption privilege.  Some of the original CEFs do not have a redemption privilege.  We would expect some of these CEFs to possibly trade at a greater discount than those that have redemption privileges.  Most of the newer CEFs provide some form of redemption privilege.  The more frequent the redemption privilege the more flexible for the investors.  Some offering documents provide redemption privileges equal to 100 per cent of NAV.  Other less attractive CEFs may have redemption privileges equal to 90 or 95 per cent of NAV.  Individuals who have closed end funds should be aware of these redemption dates, if applicable.  The offering document generally provides full details with respect to redemption privileges.

Ongoing Management

Companies may establish a CEF (rather than an OEF) for the ease of administration.  After the initial offering, management knows the amount of funds available for investment purposes.  Administratively they do not have to be concerned about additional purchases or early redemptions.  Redemption rights by investors generally must be provided to the issuer well in advance and settlement may be longer than the normal three days.

Income Payments

CEFs may be structured in a manner that provides a regular stream of income to investors.  Some structures are more beneficial in a non-registered account if the income payments are tax efficient.

Typical CEFs

The following are the main categories of CEFs:  global equity, income and growth funds, fixed income funds, preferred share funds, income trust funds, commodity funds, infrastructure funds, and alternative asset management funds.

We encourage all investors considering a closed end fund to understand the limitations and risks.

Principal protected notes require this checklist

Principal Protected Notes (PPNs) have significantly grown in popularity over the last five years as issuers provide a partial or full guarantee of the original capital if held to maturity.

There are many different strategies and structures available to retail investors, and the products are heavily marketed and are becoming increasingly complex.

There are mixed opinions in the financial community on whether PPNs make for good investments as not all are the same and should be evaluated on their individual merits.

The potential performance of the underlying investments, time horizon, and liquidity may be significantly different from structure to structure.  Your existing investments, investment objectives and risk tolerance are key components to consider prior to determining suitability.

Here’s a general overview of how PPNs work:

They are structured products that generally have a pre-packaged investment strategy, which, at times involve a combination of fixed income and derivatives (options, forward agreements, swaps, etc.) and may use leverage.

For example, Mr. Murray invests $10,000 dollars into a principal protected note (PPN).  The issuer of the PPN invests a portion of this money in a risk free bond, which will generate sufficient interest to grow to $10,000 after a period of time, generally 5 or more years.   The bond currently costs $8,000 but will grow to $10,000 at maturity. With the remaining $2,000 the issuer of the PPN may purchase other investments and derivatives consistent with the strategy.   It is this $2,000 component that provides the investor the ability to obtain a return on their investment.   The $8,000 used to purchase the fixed income ensures you receive your initial capital back.  Other PPNs may use more complex protection strategies.

Here’s a 10-point checklist to consider:

  1. Fee Transparency:  Many PPNs advertise no management expense ratio (MER), but this can be misleading.   There are definitely fees associated with these products and some can be expensive.  With many structured products there are selling commissions and fees incurred by the company offering the PPN to set up the structure and the protection strategy.  There are also ongoing costs to manage the structure.
  2. Call Features:  Some PPns are “callable,” which is an advantage for the issuing company.  If a PPN is doing well, the company may have the right to call the note.  Some PPNs are not callable and investors researching PPNs should find the non-callable types more appealing.
  3. Liquidity:  PPNs generally have a one or two year holding period.   If an investor sells the investment during the holding period a redemption fee may apply.  Prior to purchasing a PPN you should also determine how many years the investment must be held to obtain the principal protection.  The time period generally ranges from three to ten years.  Interest rates, the cost of protection, and the type of protection are all factors that impact the time period of the structure.  Investors should obtain an understanding of both the holding period (to sell without DSC) and the principal protection period.  These periods should be consistent with your investment time horizon.
  4. FundServe:  Many PPNs are beginning to trade on FundServe which is the same order entry system used by mutual funds.  This provides greater transparency and liquidity.
  5. Income:  Care should be taken to understand the type of income distribution and whether the payments are guaranteed or not.  Many of these structures enable the income stream to be treated in a more tax-efficient manner, which is important if the investment is held in a non-registered account.  Some PPN structures have a guaranteed distribution while others do not.  Many investors may find the guaranteed distribution attractive but there may be disadvantages to such a structure.
  6. Viability:  A key item for individuals considering PPNs is the viability of the firm.  Who is guaranteeing the PPN?  How much exposure does the company have to this type of structure?  Will they be able to follow through with the guarantee if there is a significant market correction?
  7. Leverage:  Investors should ask if the structure they are considering uses leverage.  Understanding leverage and its potential use may be required to obtain an understanding of the associated risks and rewards.
  8. Volatility:  The underlying investments and the use of leverage will impact the level of volatility of a PPN structure.  Volatility may also be caused by limited liquidity although many issuers are now providing an active secondary market
  9. Limited Upside:  Several PPN structures have limits on the upside potential of the investment.  Investors should be aware if the PPN has any capping features.  Prior to investing, people should ask what component of any positive performance would they participate in.
  10. The Structure:  A good rule of thumb is to avoid investments that you do not understand and that seem overly complicated.  If you do not understand the investment structure prior to purchase then it is unlikely that you will be able to appropriately monitor the position.

When segregated funds make sense

Segregated funds are structured very much like mutual funds, but are issued through an insurance company rather than an investment or fund company. As a result, segregated funds – also known as individual variable annuities – are governed by the Insurance Act. Segregated funds are more expensive than conventional mutual funds but some investors may feel the additional cost is worth it.

Each insurance company has different features with respect to their own segregated funds. The comments below may not apply to all types of segregated funds, but helps to provide a general overview. Within each section we will compare segregated funds against regular mutual funds.

Guarantees: Segregated funds come with two types of guarantees. The first type is a death benefit guarantee. This guarantee generally provides for the higher of the original principal invested or the current market value in the event of death. The second type of guarantee is the maturity guarantee. The maturity guarantee is normally between 75 and 100 per cent of the original deposit. In order for the maturity guarantee to apply the holding period is generally 10 years. Mutual funds have no guarantees.

Resets: Certain types of segregated funds allow contract holders to reset the maturity and death benefit guarantees. Resets are only done when the market value is greater than the original amount invested. Not all segregated funds have the ability to reset and are generally only permitted to certain ages (i.e. age 90).

Scenario 1: Three years ago an individual invested $50,000 into Segregated Fund A. Today the fund is worth $70,000. You may choose to reset the maturity and death benefits from that date. This means that the guarantees noted above are now based on the $70,000 and not the original $50,000 and the maturity date is 10 years from the reset date.

Scenario 2: Seven years ago an individual invested $50,000 into Segregated Fund B. Today the fund is worth $35,000. This individual should not reset the contract as the market value is below the original investment. Mutual funds have no reset ability.

Fund Selection: Individuals investing in a particular segregated fund contract may be able to select from a group of different funds. A particular series of segregated funds may have a group of brand name funds to choose from. The selection for individual mutual funds is generally far greater. The fund contract may allow the unit holder to switch within certain funds in the group without resetting the maturity date.

Probate: With a segregated fund contract a beneficiary is named. Provided the estate does not name the beneficiary the death benefit proceeds bypass the estate and are distributed more efficiently to the beneficiary. Probate fees generally do not apply to segregated funds when beneficiaries are named and general administration fees are typically lower. Mutual funds held in an individual account may be subject to probate fees.

Age Limitation: Most segregated fund contracts may only be established for those individuals under certain ages (i.e. 90 years old). Mutual funds have no maximum age limits.

Creditor Protection: Segregated funds may be protected from creditors if a spouse, child, grandchild or parent is named as the beneficiary. Younger professionals and entrepreneurs may find this feature particularly beneficial. Mutual funds may not have this same creditor protection feature.

Fees: Both segregated funds and mutual funds have fees attached to them. The fees are often referred to as the management expense ratio (MER). The more benefits that a segregated fund has, the higher its MER. The following lists the same underlying fund and the annual MER:
• 2.78% Segregated Fund – series I
• 2.35% Segregated Fund – series II
• 2.19% Mutual Fund

The highest MER relates to Segregated Fund – Series I with 2.78 per cent. The fees are higher than the other two primarily because it has a 100 per cent maturity guarantee. Segregated Fund – Series II has lower fees than the series I but only has a maturity guarantee of 75 per cent. Both Segregated Funds have a 100 per cent death benefit guarantee. The Segregated Funds are invested in the same underlying fund as the regular Mutual Fund. The MER on the Mutual Fund is the lowest at 2.19 per cent; however, this fund has no maturity guarantees and no death benefit. The MER comparison highlights that the above benefits come at a cost.

Who Should Invest?

Segregated funds are suitable for a wide range of individuals. Professionals and entrepreneurs in higher risk professions may be attracted to the creditor protection features. Individuals with a lower tolerance for risk may want to ensure their equity investments have some protection. Seniors may benefit the most if they implement segregated funds into their estate plan.

Before implementing any strategy noted in our columns we recommend that individuals consult with their professional advisors (insurance consultant, financial advisor, accountant and estate lawyer).

Unmasking F-Class Funds

F-Class mutual funds are gaining in popularity as investors begin to understand the benefits.  Designated in 1999, they are available for fee-based clients only, and the majority of fund companies offer them.

To understand F-Class we need to understand the types of fees associated with mutual funds.  All mutual funds have annual fees and service fees.  Combined they are often referred to as the Management Expense Ratio (MER).  The annual fees include the fees to the portfolio manager and the ongoing expenses of the fund.  The service fee is the amount that is paid to the investment firm that is holding the investment, a portion of which is generally paid to the advisor.

Let’s use a fictional mutual fund called XYZ Fund.  The XYZ Fund has an annual MER of three per cent that is comprised of an investment management fee of one and a half per cent, administrative and operating expenses of a half of a per cent and a service fee (often referred to as trailer fees) of one per cent.  With regular mutual funds, the three per cent is deducted from the adjusted cost base of the fund and the mutual fund company sends the servicing firm one per cent.  With F-Class mutual funds, only two per cent would be deducted within the fund and the fund company does not compensate the servicing firm.

How is F-Class different?

The structure of the MER is different with F-Class mutual funds than with regular mutual funds.  Fee-based clients are already paying a fee to their advisor based on the assets in their account (including mutual funds) so the fund companies have eliminated the advisor commission component, thereby eliminating a duplication of fees for the client.  The F-Class version simply excludes the one per cent service fee, making the XYZ Fund available with an MER of two per cent (rather than three per cent).

Why is this important?

Five reasons why we like F-Class:  1) Fee Transparency, 2) Fee Flexibility, 3) Commission, 4) Tax Efficiency, and 5) Benefits for RRSPs and RRIFs

1.  Fee Transparency:  With regular mutual funds the fees are embedded in the unit price and are not transparent unless one is inclined to read through the prospectus and financial reports.  The unit value of the fund declines when the fees are charged.  With F-Class funds the investment management fees and administrative and operating expenses totaling two per cent are still embedded in the unit price.  The service fee is charged by the investment firm directly allowing the individual investor to clearly see the fees paid.

2.  Fee Flexibility:  With regular class mutual funds the ongoing fees paid to the investment firm are set by the mutual fund company, there is no flexibility.  With fee-based accounts, the client and advisor agree on an appropriate fee to be charged.

3.  Commission:  The majority of mutual funds have been purchased on either a front-end (initial service charge) or back-end (deferred sales charge) basis.  Front-end means that the investor paid a commission to the investment firm when the fund was first purchased.  With back-end purchases, the fund company paid the investment firm the commission at the beginning and the investor paid no commission.  If the investor sells the position, the fund company will charge the investor a redemption fee that declines with time; however, this is generally zero if the fund was held for seven years or more.  F-Class is considered no-load as it has no commissions to purchase or sell, resulting in greater flexibility.

4.  Tax Efficiency:  For non-registered accounts the quarterly fees charged for F-Class are fully deductible on schedule four of your tax return when paid, even though you may still hold the underlying security.  With regular mutual funds the fees are deducted automatically and have the effect of lowering the current market value of the fund.  When you ultimately sell the regular mutual fund then the difference between the adjusted cost base and the current market value is a capital gain (loss).  As only one half of capital gains are taxable, investors are essentially only getting a deduction for half of the embedded fees.

5.  Benefits for RRSPs and RRIFs:  Although investors are not able to deduct the fees associated with F-Class mutual funds held within a registered accounts they are able to pay the fees by contributing outside money.  Contributions into the account to pay fees are not deductible; however, this does allow the investments within the account to compound even more.

F-class is one of the benefits available to investors that have a fee-based account.  You may want to talk to your advisor to see if a fee-based account is right for you.

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.