Mutual funds are a huge deal in Canada, with over $2 trillion invested as of May 2024. Compare that to the $429.2 billion in ETFs, and you’ll see mutual funds is still almost 5 times as popular.
As a former financial advisor at a Big Bank in Canada, I’ve seen the many hidden downsides of mutual funds, which I’m going to share with you today.
In this video, I’ll break down 5 reasons why mutual funds may not be your best bet, why they’re so popular, and some smarter alternatives you should consider.
What Exactly is a Mutual Fund
When I mention mutual funds, I’m specifically referring to the high-cost, actively managed ones. These funds pool money from many investors to buy a diverse portfolio of stocks, bonds, or other securities.
The funds are usually overseen by professional portfolio managers or teams who make strategic decisions about buying and selling assets to try and outperform a benchmark. Unfortunately, in the case of Canadian mutual funds, they fall short of this goal more often than not, and a large reason why is due to….
1. High Fees
Mutual fund fees in Canada remain among the highest in the world. The average asset-weighted management expense ratio for equity funds is still around 1.76%, and for allocation funds it’s about 1.90%, and for fixed-income funds it’s 0.89%, according to Morningstar’s latest 2022 report.
Take a look at TD Bank’s Mutual fund page, and you’ll see that many of the equity fund Management Expense Ratios, (MERs) are over 2%. I do not mean to pick on TD Bank, all the Big 5 banks have similar pricing.
When we talk about a 2% management fee on a mutual fund, it doesn’t sound like much. However, this seemingly small percentage can have a massive impact on your investment returns over the long term. Let me show you how.
Meet Kim, who invests $100,000 in a mutual fund with an average annual return of 7%. Without any fees, Kim’s investment would grow to about $387,000 over 20 years. But if she’s paying a 2% fee each year, her actual return is only 5% after fees. Over the same 20 years, Kim’s investment grows to just $265,000. That’s a difference of $122,000 – nearly a third of her potential returns wiped out by fees.
Over 30 years, the impact is even more dramatic. Without fees, Kim’s $100,000 grows to $761,000. With a 2% fee, it grows to just $432,000. That’s a difference of $329,000 – or 43% of her potential returns gone to fees. This shows that the 2% fee isn’t just 2% of your returns, it effectively takes away a large chunk of your potential gains due to the power of compounding interest.
It’s not all doom and gloom, though. Mutual fund fees in Canada have decreased slightly over the past few years. The introduction of fee-based advice and regulatory changes, like the Client Focused Reforms, have pushed the industry towards greater transparency and slightly lower costs.
But you might be thinking – aren’t the fees worth it, if I have a rock star fund manager who knocks it out of the park and makes me a lot of money? Well, let’s get into the second reason why mutual funds are a rip off:
2. Low Returns
A significant percentage of actively managed funds in Canada underperform their respective benchmarks over various time horizons, according to SPIVA. For instance, over a ten-year period, 96.63% of Canadian Equity funds underperformed their benchmark, the S&P/TSX Composite Index.
To put this into perspective, the S&P/TSX Composite Index gained an annualized return of 7.62% over the last ten years. In contrast, Canadian Equity funds managed only 5.64% on an equal-weighted basis. This means that the vast majority of actively managed Canadian mutual funds fail to match, let alone beat, the market index.
Hmm, it’s Funny how that difference is almost exactly the 2% in fees charged, isn’t it! It’s almost like these active managers all perform at the average before fees, doesn’t it? And we all know how much a difference 2% makes now, based on our previous example.
This underperformance isn’t limited to a single category of funds. For Canadian Focused Equity funds, 98.04% underperformed their benchmark over the same ten-year period. Similarly, for Canadian Dividend & Income Equity funds, 88.06% fell short of their benchmark. Even over shorter periods, like five and three years, the majority of these funds continue to lag behind their benchmarks.
The problem extends beyond just large-cap equity funds. 76.19% of Canadian Small-/Mid-Cap Equity funds underperformed their benchmark over the past ten years. This consistent underperformance across different fund categories highlights a systemic issue within the mutual fund industry in Canada.
So with mutual funds, we got high fees, for lesser returns overall. Sounds like quite the rip off, doesn’t it? I like to think of it like going to a fancy Restaurant with bad food: Imagine you’re going to a fancy, expensive restaurant expecting a gourmet meal.
However, the food is bland and poorly prepared. You’re paying a premium for a dining experience that is actually worse than a regular, cheaper restaurant. High mutual fund fees are like this: many people pay a premium expecting high returns but often get subpar performance.
3. Tricky Marketing Tactics
How Banks Use Marketing to Cloud the Truth
Banks and financial institutions often highlight the success stories among mutual funds, showcasing only the top-performing funds. 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.
For instance, advertisements from banks typically feature impressive returns from the top performers, conveniently omitting the many other funds that underperformed and were quietly closed down. This marketing tactic leads you to believe in an overall high performance that doesn’t reflect the full reality.
It’s kind of like watching a movie trailer that only includes the most exciting, well-made scenes, but the rest of the movie is poorly executed.
Viewers are misled into thinking the entire movie is great, when in reality, it is mostly terrible. Similarly, banks focus on the top-performing funds, giving an illusion of consistent high returns.
Survivorship Bias
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.
Over a ten-year period, 43% of Canadian Equity funds were either merged or liquidated as of 2023. On average, across all categories, 39% of funds disappeared. Specifically, only 57.3% of Canadian Equity funds survived, and for Canadian-focused equity funds, the survivorship rate was even lower at 43.14%.
Think about how crazy that is! Imagine if 39% of restaurants in your city closed down because they were so bad, but only the top ones remained and advertised their success stories. You’d think the dining scene was thriving, but in reality, you’d be missing a huge part of the picture.
Banks and financial institutions use survivorship bias to their advantage, highlighting the success stories among mutual funds and showcasing only the top performers. This selective reporting gives the illusion of consistent high performance, misleading investors into believing that the mutual fund industry is doing better than it actually is.
4. Tax Inefficiency Concerns
Let’s talk about something that’s often overlooked with mutual funds in Canada: tax inefficiency. This can really hit your returns, especially if you’re holding these funds in a non-registered taxable account.
- Capital Gains Distributions: Every year, mutual funds have to distribute any realized capital gains to their investors. So, even if you haven’t sold any shares, you could end up paying taxes on gains you didn’t directly benefit from. Imagine investing in January, the fund sells some appreciated holdings in December, and boom—you’re hit with a capital gains distribution and a tax bill.
- Frequent Trading: Actively managed mutual funds love to trade frequently, which means lots of short-term capital gains. The catch? These gains are taxed at a higher rate than long-term gains. If your fund manager is buying and selling within the same year, those profits are taxed at your regular income tax rate, which is way higher than the long-term rate.
- Lack of Control Over Tax Timing: With mutual funds, you’re at the mercy of the fund manager’s decisions on when to realize gains or losses. This can lead to taxable events at the worst possible times, increasing your tax liability. You might be planning to hold your investment long-term to benefit from lower tax rates, but the fund manager’s moves can mess that up with frequent taxable events.
Why Are Mutual Funds in Canada so Popular?
Despite all this, why is over $2 trillion invested in mutual funds in Canada? I’ll break down what I think are the 3 biggest reasons:
5. Aggressive Distribution and Sales
Accessibility and Convenience: Mutual funds are incredibly easy to access and convenient for the average investor. They offer a straightforward way to diversify across various asset classes without needing extensive market knowledge or large amounts of capital. Banks and financial advisors make it easy to buy mutual funds, often pushing them due to aggressive sales targets, which leads many Canadians to invest in them over more cost-effective options.
Professional Management: Many investors are drawn to mutual funds because they are managed by professional portfolio managers. These managers are seen as experts who can make informed investment decisions, appealing to those who prefer a hands-off approach. Despite the data showing otherwise, people like to believe in the expertise of these managers, hoping they can achieve high returns.
Marketing and Branding: We covered this earlier, but banks and financial institutions heavily market mutual funds, highlighting their potential for high returns and professional management. This marketing, along with the trust and reputation of large financial institutions, convinces many investors to choose mutual funds over other options. Tactics like Morningstar’s five-star ratings can mislead investors into believing they will achieve better performance.
Alternatives to Mutual Funds in Canada
Here are some viable alternatives to mutual funds in Canada. I’ve ordered it From easiest to most difficult to implement.
Robo-advisors
Robo-advisors offer a convenient and cost-effective way to invest, typically charging lower fees than traditional mutual funds. Fees can be about half of what you’d pay for mutual funds. I like Questwealth, as it charges lower fees compared to the more popular Wealthsimple
Portfolio Managers
Hiring a portfolio manager can often be a more cost-effective choice than investing in mutual funds. These professionals create personalized investment strategies tailored to your financial goals and risk tolerance, offering the expertise of professional management typically at lower fees than mutual funds. At Blueprint, we’ve partnered with some exceptional portfolio managers, and you can learn more about them on our website.
Build Own ETF Portfolios
The tide is turning in favor of ETFs over mutual funds. In May, mutual funds experienced net redemptions of $1.8 billion, while ETFs saw net sales of $4.4 billion. Building your own ETF portfolio can offer greater flexibility, lower fees, and better tax efficiency compared to mutual funds.
DIY Stock Portfolio
For those willing to put in the time and effort, creating a DIY stock portfolio is the most hands-on and potentially rewarding alternative. This approach allows you to directly control your investments, minimize fees, and tailor your portfolio to your specific preferences. However, it requires significant knowledge, research, and time commitment.
Here’s a summary table of these alternatives, consider trying one one of these methods out or doing more research on what appeals to you:
Mutual funds in Canada might seem like a popular choice, but high fees and underperformance can really impact your returns. For more insights about making the most of your investments, visit the investment management services of this website, and book a free consultation when ready!
