If you invest in Canada, chances are you’ve considered mutual funds. With over $2 trillion invested, they remain a popular choice compared to ETFs. But as a former financial adviser, I’ve seen the hidden downsides. In this video, we’ll explore why mutual funds might not be your best option, why they’re so popular, and more effective alternatives.
Mutual funds pool money from many investors and are managed by professionals aiming to beat a benchmark. Yet, despite high hopes, they often fall short. High fees and low returns are just part of the story. Stick around to learn the full picture and find smarter options for your investments.
Key Takeaways
- Understanding mutual funds is essential before investing.
- High fees can significantly impact your returns.
- Exploring alternatives may offer better financial outcomes.
Learning About Mutual Funds
Mutual funds are a big deal in Canada. They have over $2 trillion invested as of May 2024. This is much more than the $429 billion in exchange-traded funds (ETFs). When people invest in mutual funds, they pool their money together. This money is then used to buy a variety of stocks, bonds, or other securities. These funds are often managed by professional portfolio managers who make strategic decisions about buying and selling assets to try and outperform a benchmark.
Many mutual funds are actively managed, and they often come with high fees. In Canada, these fees are among the highest in the world. For instance, the average management expense ratio (MER) for equity funds is around 1.76%. For allocation funds, it’s about 1.9%, and for fixed-income funds, it’s 0.89%.
Here’s how fees can impact your investments:
Kim’s Investment Without Fees:
- Starts with: $100,000
- Average Annual Return: 7%
- Grows to: $387,000 over 20 years
Kim’s Investment With 2% Fees:
- Starts with: $100,000
- Average Annual Return: 5% (after fees)
- Grows to: $265,000 over 20 years
That’s a difference of $122,000 due to fees. The impact becomes even more dramatic over 30 years. Without fees, Kim’s investment grows to $761,000. With a 2% fee, it only grows to $432,000. That’s a difference of $329,000 or 43% of potential returns wiped out.
Mutual fund fees have decreased slightly over the past few years. Changes like fee-based advice and regulatory reforms have pushed the industry towards more transparency and slightly lower costs.
Despite high fees, many actively managed mutual funds in Canada often underperform their benchmarks. For example, over a recent 10-year period, 96.63% of Canadian equity funds did worse than the S&P/TSX Composite Index, which had an annualized return of 7.62%. In contrast, Canadian equity funds managed only 5.64%.
When mutual funds don’t perform well, it’s almost as if the managers are performing at the average before fees. This underperformance isn’t just for large-cap equity funds. For Canadian-focused equity funds, 98% performed worse than their benchmark over the same 10-year period. Similarly, 88.6% of Canadian dividend and income equity funds underperformed.
Paying high fees for subpar returns is like eating at a fancy restaurant with bad food. You expect a gourmet meal but end up with a poorly prepared dish. You’re paying a premium for an experience that’s actually worse than a cheaper, regular restaurant. High mutual fund fees are similar. Many people pay more expecting higher returns but often get less-than-stellar performance.
Banks and financial institutions sometimes use marketing to make mutual funds look better than they are. They highlight the top-performing funds and ignore the ones that performed poorly or were closed down. This creates an illusion of consistent high performance, which can mislead investors.
To see how mutual funds can mislead you, it’s important to understand survivorship bias. This happens when only surviving funds are considered in performance reports, while poorly performing funds that were merged or liquidated are excluded. This creates a misleadingly positive picture of the mutual fund industry.
Recent data shows that over a 10-year period, 43% of Canadian equity funds were merged or liquidated by 2023. On average, across all categories, 39% of funds disappeared. Only 57.3% of Canadian equity funds survived. For Canadian-focused equity funds, the survivorship rate was even lower at 43.14%.
Banks and financial institutions use this bias to their advantage, showcasing only the top performers and hiding the ones that failed.
High Fees and Their Impact
Mutual fund fees in Canada are some of the highest in the world. For equity funds, the average Management Expense Ratio (MER) is roughly 1.76%, for allocation funds it’s roughly 1.9%, and for fixed income funds it’s about 0.89%. These fees can have a large impact on your investment returns over time.
The Long-Term Effect of Fees
If you invest $100,000 and it grows at an average annual rate of 7% without fees, it would amount to approximately $387,000 after 20 years. With a 2% annual fee, your effective return is 5%. Over 20 years, your investment grows to only about $265,000—a difference of $122,000 taken by fees.
| Investment Duration | No Fees | With 2% Fee |
|---|---|---|
| 20 years | $387,000 | $265,000 |
| 30 years | $761,000 | $432,000 |
Compounding Fees Over Time
The fees don’t simply reduce your returns by 2%. Because of compounding, the impact is even larger over longer periods. After 30 years, the $100,000 would grow to $761,000 without fees, but only $432,000 with the 2% fee—a staggering $329,000 difference.
Regulatory Changes
Recent changes in regulations have led to a slight decrease in mutual fund fees in Canada. Fee-based advice and transparency reforms have started to push fees down somewhat. Despite these changes, the longstanding high costs continue to erode significant portions of your investment’s growth.
Disappointing Returns vs. Benchmarks
When you invest in a mutual fund, you might expect those professionals managing your money to outperform the market. Sadly, that’s not often the case. For Canadian mutual funds, a significant percentage of actively managed funds don’t even match the benchmarks they’re supposed to beat.
Canadian Equity Funds vs. S&P TSX Composite Index:
- Over 10 years: 96.63% of funds underperformed.
- S&P TSX returned an annualized rate of 7.62%.
- Canadian Equity Funds managed only 5.64%.
This difference closely matches the 2% fee, illustrating how much fees can affect performance. This underperformance isn’t limited to a single category. In Canadian-focused Equity Funds, 98% fell short, and even in Dividend and Income Equity Funds, 88.6% lagged behind.
Even in periods as short as five and three years, the majority of these funds continue to trail behind their benchmarks. It’s clear that high fees lead to lower returns. Imagine expecting a gourmet meal at a fancy restaurant and getting bland food instead. In the same way, many investors pay premium fees for mutual funds expecting higher gains, only to receive average or subpar performance.
Tricky Marketing Tactics
Banks and financial institutions often highlight the success stories among mutual funds, showcasing only the top-performing ones. This selective reporting ignores the underperforming funds that were closed or merged out of existence. By doing this, they create an illusion of consistent high performance. In reality, many people end up investing in these underperforming funds and see lower returns.
For example, advertisements from banks may feature impressive returns from top performers, conveniently omitting the many other funds that underperformed and were quietly closed down. This tactic makes you believe in an overall high performance that doesn’t reflect the true situation.
It’s kind of like watching a movie trailer that only includes the most exciting scenes, but when you sit down to watch the movie, it’s disappointing. Viewers are misled into thinking the entire movie is great when in reality, it’s mostly not.
To understand how mutual funds can mislead you, it’s crucial to grasp the concept of survivorship bias. This happens when only the surviving funds are considered in performance reports, while poorly performing funds that were merged or liquidated are excluded. This creates a misleadingly positive picture of the mutual fund industry.
The Problem of Survivorship Bias
Banks and financial institutions love to show off their best-performing mutual funds to attract investors. This approach can be misleading as it often ignores the poor-performing funds that were closed or merged out of existence. This selective reporting creates an illusion that mutual funds perform better than they actually do.
Survivorship Bias
Survivorship bias paints a misleadingly positive picture of the mutual fund industry’s performance. Here’s what happens: only funds that have survived are considered in performance reports. Meanwhile, funds that didn’t perform well and were either merged or liquidated are excluded. This skews the data and gives you an inaccurate view of the true performance of mutual funds.
The Numbers
To get a clear picture, let’s look at the data:
- Over a recent 10-year period, 43% of Canadian equity funds were either merged or liquidated.
- On average, across all categories, 39% of funds disappeared.
- Only 57.3% of Canadian equity funds survived.
- For Canadian-focused equity funds, the survivorship rate was even lower at 43.14%.
Real-World Example
Imagine if 39% of restaurants in your city closed down because they were so bad, but the remaining ones kept advertising their success stories. You might think the dining scene in your city is thriving. You’d believe everyone only eats at great restaurants. However, you’d be missing a huge part of the picture. The same happens with mutual funds. By highlighting only the top performers, banks hide the vast number of funds that underperformed and subsequently closed.
This selective reporting can lead you to believe that mutual funds perform consistently well. In reality, many people invest in underperforming funds and experience lower returns.
Essential Alternatives to Consider
Exchange-Traded Funds (ETFs)
ETFs are a popular choice. Unlike mutual funds, ETFs usually have lower fees. They trade on stock exchanges, similar to individual stocks. This means you can buy and sell them throughout the trading day at market prices. They also often track various indexes, which can give you exposure to a diverse range of assets.
Robo-Advisors
Robo-advisors use algorithms to create and manage a diversified portfolio. They offer automated investment services at a low cost. By answering a few questions about your risk tolerance and financial goals, you can get a tailored investment strategy without paying high fees.
Dividend Stocks
Investing in dividend-paying stocks can provide a steady income stream. Look for companies with a strong track record of paying dividends. If you reinvest the dividends, your investment can grow significantly over time.
High-Interest Savings Accounts
For those who prefer less risk, high-interest savings accounts can be a good option. These accounts offer more interest than regular savings accounts. They are a safer place to park your money, especially if you need quick access to your funds.
Real Estate Investment Trusts (REITs)
REITs allow you to invest in real estate without having to buy properties yourself. They pool money from many investors to buy and manage income-producing properties. REITs often pay out high dividends and can be traded like stocks.
Bonds
Bonds are debt securities issued by corporations or governments. They can provide regular interest payments and are generally less risky than stocks. Including bonds in your portfolio can help balance risk and provide stable returns.
Peer-to-Peer Lending
Peer-to-peer lending platforms connect borrowers with investors. As an investor, you can earn interest by lending money directly to individuals or small businesses. This can offer higher returns but comes with higher risk compared to traditional savings accounts or bonds.
