Skimming Off The Top

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Mutual funds have been extremely popular for Canadians, especially those that want to invest in the stock market with very little experience.  If you don’t know what mutual funds are, the explanation is quite simple.  First off they are not a type of account that you can open at a bank or brokerage.  Mutual funds are a financial instrument you can buy, just like a stock or bond.  Generally, mutual funds will contain many stocks or bonds so when you buy a share in a mutual fund you are essentially investing in many companies or perhaps holding many bonds.  In essence, buying mutual funds means you can diversify your investments and purchase  shares in many companies which you might not otherwise be able to do if you don’t have a lot of money to invest.  If you own a mutual fund, then you no longer have to worry about picking what stocks or bonds to buy because that duty now falls on the manager of the mutual fund.  To buy mutual funds you would open a brokerage account at your financial institution and buy and trade them just like stocks.

So mutual funds sound great!  Someone manages your money for you.  They are professionals and you know nothing about stocks and bonds, so they must be doing a better job for you than you would yourself.  You’ve always heard that mutual fund managers make a lot money, so you must be getting great value.  Let’s hold that enthusiasm for one second.

When you speak with a financial advisor, either from the bank or a brokerage, they are more likely to lead you down the path of buying mutual funds as a way to save for retirement and build wealth.  Most of this advice is free and you pay nary a cent to the advisor for the advice that you are receiving.  So do you ever wonder how these advisors are giving you financial advice, but you never have to pay them a cent?  Does good advice ever come for free?

Little do you know, most financial planners and advisors are really just sales people.  They are there to sell you a product because it will pad their bottom line and it makes their company money.  If these financial planners did not make the company money, how else would their salary get paid?  Banks and brokerage firms don’t give out jobs for free.  There is a reason that they make over a billion dollars each fiscal quarter.  Advisors will pitch mutual funds because they get paid selling them.  That’s right, a mutual fund has many fees associated with holding one.  As many Canadians are starting to realize, mutual funds carry very expensive fees that are often labelled as a Management Expense Ratio.

Each mutual funds needs to pay the managers, the analyst and the administrators to keep that fund going.  When you buy mutual funds there is no transaction fee, so where is the money coming from?  To keep it simple, mutual funds just take money from the investors to keep their operations going.  It’s as simple as that.  They skim off the top of the fund every year.  Let’s take a look at this hypothetical situation.

  • A new mutual fund is offered for sale at $20 a share. 
  • 10 000 individuals decide to buy 500 shares each of that mutual fund
  • The fund now has $100 000 000 in assets to invest.
  • Since the fund needs to pay people to make it work they take 2% out of the fund every year.  This equals $2 000 000.

Regardless if any money is made for the holders of the mutual funds, this expense is incurred.  Champions of mutual funds will say that this expense is required because there is a team of professional, financial experts helping you make the right decision.  Truth be told, this is a bunch of bull.  Ask your advisor if the fund will stop taking away money if it performs poorly for the year or has a net loss.  The answer will be no.

So before you even make any money you’re already down the 2%.  Imagine sitting down to write an exam with a score of 100 and only 100 possible marks, but you’re starting out at -2.  That’s already made things a lot tougher.  Since there are only 100 points to score, you’re already limiting yourself to a maximum of 98.  That’s what happens when you buy a mutual fund with a high Management Expense Ratio.  You’ve already handicapped yourself from achieving the maximum return.

So why do advisors tell you to buy certain mutual funds?  Easy.  They get a commission on selling you the mutual fund.  Essentially part of the MER of the mutual fund ends up going to the “sellers” of the mutual fund.

Now you’re probably very skeptical of mutual funds.  Luckily not all mutual funds are created equal.  On top of that, I did say mutual funds were one of the better ways to diversify your portfolio and spread your money out amongst many assets.  So how do you go about seeing what the best mutual funds are?  For starters, there is a great site for researching mutual funds call Morningstar.  Morningstar is your one stop shop to research almost every mutual fund available to Canadians.  You can research and view what the mutual funds hold, see its past performance and figure out what the Management Expense Ratio is.

Check a screenshot:

morningstar

Once you are armed with the knowledge of knowing what to look for, you no longer have to be at the mercy of a financial advisor dictating to you what you should buy.  You should be able to make that decision for yourself.  As I end this post, I’ll leave you with a few words from John Bogle, founder of the Vanguard Group, “You get what you don’t pay for.”  Think about it.

Stay tuned for my next part on mutual funds…

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5 thoughts on “Skimming Off The Top

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