Cheap doesn’t necessarily mean better in financial planning

Investors must consider risk and rate of return before chasing options with lower fees

Everyone knows the expression “penny-wise and pound-foolish.” It’s an old English phrase that refers to someone who is tight-fisted about small expenses but careless when it comes to big-ticket items.

A lot of investors fall into this category. They move their money into the lowest cost securities they can find without paying much attention to the bottom line impact. In some cases, the end result is to save a few pennies in fees while potentially losing many dollars in profits.

I was reminded of this again recently when I received this email from a reader: “My wife and I transferred our RRSP/RRIF portfolio from a broker to a bank balanced fund primarily due to lower fees. Do you consider balanced funds to be a safe bet?”

Clearly, the main motive for this move was “lower fees.” In fact, that should be way down on the priority list when it comes to financial decisions. It’s more important to focus on the after-fees return your investments are generating and the risk-return balance in the portfolio. We don’t know the numbers in this case, but the tone of the question suggests the reader didn’t even take those factors into account. Instead, he worries about whether the balanced funds he and his wife have purchased are “a safe bet.” That’s something he should have considered before he made the decision. And if he was so concerned about risk, he should have asked the broker for suggestions before making the switch.

So there are really two issues here. The first is cost. There’s a lot of price competition going on in the wealth- management industry right now, with exchange-traded funds (ETFs) and robo-advisors undercutting the costs of traditional mutual funds and full-service advisers in what is turning out to be a successful bid to increase market share.

As I have written here before, the ETF market in Canada is growing at an impressive rate. Despite a slowdown in the second quarter, ETF assets grew by 3.4 per cent over the three months to the end of June to reach a new highwater mark of $157 billion.

To that point, ETFs accounted for 41 per cent of investment fund net inflows and have consequently increased their share of total fund assets to 9.4 per cent, which was up 90 basis points from 12 months prior, according to the Canadian ETF Association.

I could not find any statistics about the amount of money Canadians have invested with robo-advisers but our largest firm, Wealthsimple, claims to have more than $2 billion in assets under management after just four years in operation.

Obviously, Canadians investors like products that are cheap.

That doesn’t mean cheap is bad. There are no reliable statistics for robo-advisors, but many ETFs have outperformed actively managed mutual funds, sometimes by a wide margin.

But there are categories where ETFs have not yet ven- tured to any degree. Balanced investing (a mixture of stocks and bonds) is one. There are a few out there, but they are rare. And more conservative investors should be looking at balanced portfolios as a way to reduce risk.

That brings me back to the second part of the reader’s question: is a balanced fund “safe”? The answer is that it depends on how much of the portfolio is invested in stocks and how much in bonds and cash. The higher the equity weighting, the riskier the fund becomes. The same would apply to a portfolio constructed by a robo-advisor.

For example, the TD Balanced Growth Investor Series, which is in the Canadian equity balanced category, has about two-thirds of its assets invested in the stock market. It lost almost 23 per cent in the crash of 2008-09. By contrast, the Steadyhand Income Fund, which is classified as a fixed income balanced fund, invests only about 28 per cent of its assets in stocks. It was down only 10.5 per cent in the same period. The TD fund generates better returns when markets are strong. But the Steadyhand Fund is the safer bet when stocks fall.

Bottom line: Cost should not be the sole criteria when making an investment decision. Risk and net return potential are much more important.