How mutual funds could save you
Beware mutual funds that look like index funds but perform and cost like the former
Imagine you went to your local financial institution and you were offered two investment choices.
Each investment would look the same. The holdings would be roughly the same. Not surprisingly, the volatility and risk of each looked the same. The only difference is that year after year, one performed better than the other. Which one would you choose?
For many Canadians today, they are being sold a mutual fund that is an apples-to-apples underperformer. In fact, this problem is costing investors hundreds of millions of dollars every year.
RBC’s Canadian Equity fund is one of the best examples of this phenomenon, with almost $5-billion in client assets under management and a fee of 2.05% a year.
The fund has a three-year beta of 1.01. Beta is a measure of a funds’ volatility as compared to the index. For example, a beta of 0.7 is much less volatile than the index, and a beta of 1.3 is much more volatile. A beta of 1.0 on a fund suggests it will have essentially the same degree of volatility as the market index.
A measure of risk can be found in standard deviations. This fund has a three-year standard deviation of 12.93%. This means that 66% of the time, the fund will have a return of plus or minus 12.93% from the market’s long-term historical average. The TSX has a three-year standard deviation of 12.66%.
So far, we have a fund that has a very similar level of volatility and risk as the underlying stock index.
If we look at the top eight stocks by weight in the TSX, we will find Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Suncor Energy, Barrick Gold, Canadian Natural Resources, Goldcorp and Potash Corp. of Saskatchewan.
On Jan. 31, 2012, the top eight stocks in the RBC Canadian Equity fund in order were RBC, TD, Suncor Energy, Bank of Nova Scotia, Barrick Gold, Canadian Natural Resources, Goldcorp and Potash Corp.
It’s fair to say that this fund looks to invest in a very similar fashion to the index. The biggest difference is that the fund has a 2.05% annual fee or MER to deal with while the RBC Canadian Index fund has a fee of 0.71%, 1.34% cheaper than its mutual fund counterpart.
In the past few years, the index fund has outperformed the mutual fund by 1.84% a year, a little more than the 1.34% annual difference in fees.
With this consistent outperformance, why does the RBC Canadian Index fund have $570-million in assets while the underperforming RBC Canadian Equity fund has almost $5-billion? A bit of a head scratcher, isn’t it? The obvious suggestion to holders of the RBC Canadian Equity fund would be to shift your $4.9-billion to the RBC Canadian Index fund and earn on average 1.5% to 2% higher annual return. No need to change the type of investment, your financial institution or who you work with.
Of course, if your money is part of the $4.9-billion, you may ask yourself why it was suggested that you put your money in the RBC Canadian Equity fund in the first place.
When asked to comment on the issue of closet indexing with the RBC Canadian Equity fund, Yen To from RBC Global Asset Management said, “It is important to note that the RBC Canadian Equity Fund is intended to be a core Canadian equity holding and, therefore, is reflective of the S&P/TSX Composite.”
She went on to say the 2.05% MER “remains below the industry’s median MER.”
While RBC Canadian Equity is the largest example in Canada, there are a good number of other mutual funds that are closet indexers, meaning they invest very similarly to their benchmark index, but still charge an actively managed fee.
I did a review of all mutual funds with a one-year return of between -15% and -20%. Of those that came up, I reviewed their beta and volatility to see if they were within 10% of the index on both counts.
From this list, I found five funds whose top 10 holdings mostly mirrored the top 10 in the index: Desjardins Canadian Equity Growth, RBC Canadian Equity, CI Canadian Investment, Investors Canadian Equity A and London Life Canadian Equity.
These five funds each have assets
more than $1-billion and combined assets of more than $11-billion.
They have underperformed the RBC Canadian Index fund by an average of 2.93% annualized over the past five years. They also have an average fee of 2.41% as compared to the 0.71% of the RBC Canadian Index fund. In the attached chart, I have also shown the iShares TSX Capped Composite ETF as another indexing option.
The math here is significant. If we assume these funds look very much like the index, and just bought the ETF instead, the fee savings would be 2.16% a year — with a small transaction cost for the ETF.
If the $11-billion here were invested in the ETF and had the same performance except for fees, five years later, Canadian investors would have $1.07billion more than they do today after investing in these five funds.
As it turns out, these funds have underperformed beyond the fees, with a five-year return that is 3.06% worse than the ETF. With the actual performance, Canadian investors would have $1.5-billion more in their pockets after five years if they invested in the ETF instead of these five funds.
If you are buying the index anyway, why would one pay 2.05% to 2.74% each year for the privilege of buying
something that you can get for 0.25% as an ETF or 0.71% as an index fund? It makes no sense as an investor, and is something that an advisor really needs to be questioned on if they are recommending these funds.
One obvious question comes up here. Why would a mutual fund manager
A measure of risk can be found in standard deviations
choose to be a closet indexer? After all, it is almost impossible to show strong performance after fees when you are mirroring an index without fees. It is a surefire way to underperform.
The reality is that while it is a surefire way to underperform, it is also a guarantee that you won’t underperform by very much in any given year. In many cases, fund managers will keep their posts if they do an OK job, but will lose them if they have a very bad year. If you are a fund manager in this situation, why take the risk
of having a very bad year, when you might be able to hang around for many years, getting paid very well to essentially copy an index?
This may be a cynical view of things, but I can assure you that there is some truth to it.
It is important to remember that most mutual funds try to add value by doing something different from the index. Sometimes they add performance or lower risk and sometimes they end up doing a terrible job. In either case, they are providing something different from the indexes and ETFs that abound in the market place and should be rewarded or punished based on their results.
To be a closet indexer in 2012 with a mutual fund fee of more than 2% is a recipe for disaster. The fact that there are billions of dollars invested in these funds is something that really needs to change.
As an investor, do your part by either choosing different funds yourself or asking your advisor why they would recommend a fund that is almost guaranteed to underperform.