Method of Modern Love: How I THink About Mutual Funds

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In this Back to School edition:

  • Feature: Method Of Modern Love: How I Think About Mutual Funds
  • Looking ahead: Changes to
  • Trading note: AFT Income Fund (AFT.UN)

In the previous edition of Market Guy, I gave in and decided to start writing about mutual funds (see MG #21). Even I was surprised at how long it took for me to finally break down. Perhaps I should have addressed the topic earlier, especially given that a majority of Canadians are involved in funds in one way or another. But here’s the thing: I’ve been so obsessed with the stock market (income trust area, in particular), that any interruption would have been like asking a heroin addict if they’d switch to Tylenol. Despite all the good intentions and wishful thinking, it just ain’t happening. Those of you addicted to income product understand, and no doubt there is a 12-step program in our future. Well, I’m not sure what those 12 steps would involve. Perhaps I could include my handy, dandy 5-step approach to selecting mutual funds. Hey, you have to start somewhere. Recovery is a slow-process.

When it comes to my financial portfolio, the emphasis is overwhelmingly on stocks and as of the other day, cash. The stocks that I own are investments that I am able to follow rather closely. More importantly, these are vehicles about which I have achieved a reasonable and comfortable level of understanding. However, it’s important to recognize that it’s virtually impossible to become an expert on all of your investments…if any of them. It’s been estimated that in order to be an expert in any domain of activity, 10000 hours of deliberate practice is required. I’ve come to recognize that as I become more fully-entrenched in my career, there is only so much time that I can devote to investments (let alone 10000 hours). In fact, if someone were to ask me “how’s the portfolio?,” I’d have to ask: “Do you mean my financial portfolio or teaching portfolio?” This year I’m supervising almost 60 fourth-year honours projects, teaching a couple of first-year classes, and chairing a recruitment committee that involves speaking about the virtues of Carleton to high school students and their parents. So you can understand my confusion. There are only so many things that one can think about without having a complete meltdown.

Enter mutual funds, which at a general level, I regard primarily as investment vehicles that help me participate in markets or sectors about which I lack the confidence, knowledge, or time to follow with any rigour. I use them to help me diversify and enhance the overall balance of the portfolio. However, I will only invest in a mutual fund if there is no equivalent or compelling exchange-traded fund (ETF) available. An ETF is an open-ended mutual fund that trades on a stock exchange. You trade them like stocks, and they have many advantages over traditional mutual funds (as we’ll see). Before I get ahead of myself, here are the 5 questions I consider when purchasing mutual funds:

The Fantastic Five

  • Does this fund accomplish something unique for my portfolio?
  • Does the fund have low fees?
  • Has the fund outperformed its peers?
  • Will this investment allow me to sleep at night?
  • Is the fund relatively tax efficient?

Sounds simple enough. Well if it were so simple, the only 5 I’d be working with would be a 5-iron (in other words, I’d be taking a page from the book ofMarket Dad)Instead, I’m lucky if I can find the sticks in my basement. And if it were so simple, you’d be…well, I don’t know what you’d be doing. I mean we only just met and I’m not about to make assumptions. I’ve heard stories about you and those pictures on the Internet…well, let’s just move on.

Before we get started, you might be interested to know where I get my information on mutual funds. The overwhelming majority of my data is obtained from two Internet sites: Globefund and These sites give me everything I need to make, what I believe, are informed investment decisions. I also find it useful to browse through fund company websites looking for prospectus information. Now on to the five:

Does this fund accomplish something unique for my portfolio?

I know many investors who own several funds that are essentially the same. In other words, they’ll have 4 Canadian equity funds or 3 health care funds. Looking at the top holdings of each fund reveals many of the same holdings. To be honest, I don’t understand the need for duplication. Why own Pfizer or BCE 4 times? Isn’t once sufficient? (unless of course you enjoy popping Viagra while watching ExpressVu).

When choosing a specific fund, I want to make sure that it’s adding something new, rather than simply piling on to existing holdings. Ideally the fund will fill a gap and enhance the diversification of the portfolio. My first inclination is to search for an ETF. However, such products are not always available, especially in the relatively limited Canadian market. Therefore, if I want exposure to the Canadian small cap market and there is no corresponding ETF, then I will consider using a mutual fund.

Does the fund have low fees?

By now, we all know that fees matter. Fees eat into the performance of your investments and do so with alarming power. If only people were as upset with mutual fund fees as they are about taxes. I detest fees. I loathe fees. I’d rather get kicked in the groin with a steel-toed boot than pay fees. This is my religion.

My buddy Bouch in Embrun is building a house and he’s obsessed trying to make the place water and air tight. In fact, the place is going to be so completely sealed that if he farts the windows will blow out. In any event, it’s wise to be concerned about water. It’s especially adept at finding a way in and doing serious damage. Mutual fund fees are to investors as water is to the homeowner. It’s all about the rot. To completely overkill the point, allow me to present several definitions for the word, rot (courtesy of

1. To undergo decomposition, especially organic decomposition; decay.
2. To become damaged, weakened, or useless because of decay.
3. To disappear or fall by decaying.
4. To languish; decline.
5. To decay morally; become degenerate.

Sounds about right. Fees creep into the fund via a number of directions. First, we need to focus on purchase and sell fees. I focus mainly on no-load funds, but will purchase front-load funds if the broker waives the fee. Many of the discount brokerages have arrangements with the fund companies that allow them to waive the load, so it’s all gravy. The list of qualifying funds can be quite impressive and I’ve never found myself wanting to purchase a fund and then having to pay for it. I use a discount broker because I am doing the research myself and refuse to pay a full-service broker who would be acting as nothing more than a processing agent.

I will never, under any circumstances purchase a rear-load or deferred sales charge (DSC) fund. These are funds that charge you a redemption fee that declines with each year that you hold the fund. Some funds require an investment of 7 years before the fee declines to zero. Seven years? Looking at my portfolio, I can’t find one thing that I can say with certainty that I’d want to hold for 7 years. That’s too long a commitment. So Jennifer Lopez is allowed to make the ultimate commitment of marriage 5 times in 3 years (or whatever) and I can’t redeem a fund once in 7 years? This is just wrong. I know too many investors who are stuck with inappropriate DSC investments and have several more years to go before they are permitted to make an affordable exit. Many fund companies allow you to switch out of a DSC fund without incurring a penalty, but only if you keep the money within a select family of funds. But so often there are slim pickings within the family and basically all you’re doing is replacing a crappy fund with a somewhat less crappy fund. This is not the way to build a portfolio. The only people who benefit from the DSC are the fund companies. I’ve heard the old argument that you need to establish a fee structure that declines over time so that inexperienced and jumpy investors are dissuaded from frequent trading (and annoying the crap out of their brokers). However, I refuse to subscribe to the idea that fund companies are there to protect us from ourselves. I’m about to have an an aneurysm.

NO DSC has been declared a DSC-free zone  

In terms of specific funds, fees creep in mainly via the management expense ratio (MER). This includes all the expenses of running and advertising the fund. Don’t think fees matter? Even a quarter point difference in fees can result in thousands of dollars of lost money over the life of a portfolio. It’s quite remarkable. Play around with the iUnits MER Calculatorprovided by Barclays, the managers of all those Canadian ETF’s (iUnits). If you want something more, Industry Canada provides a Mutual Fund Fee Impact Calculator, and a very detailed version is also offered by the Investor Education Fund. Powerful stuff.

I will only purchase funds that offer an MER that is below average for its category. For example, according to PH&N, the average MER for a US equity fund is 2.43%. You’re telling me that in this day and age when Warren Buffett says we should expect mid to high single-digit returns from equities, I should be paying 2.43% to the managers? Paying 2.43% to make single digits? That’s insane. If the managers are outperforming the indices, then we’ll talk. But so many fail to even match the indices…and I can pick up a US exchange traded fund with an MER well south of 1%. Where do you think I’m going to send my money?

A below-average MER tells me the fund company has placed a high priority on me. It imposes a discipline on the managers in the same way that having to pay a regular dividend imposes discipline on a company. A lower MER shows me the managers are confident in their ability to generate wealth for me and for themselves. In other words, our interests are more fully-linked. It also suggests that maybe, just maybe, the firm is less interested in advertising expenses and wooing new clients and more interested in making money for existing holders. It shows me they are willing to let performance serve as its own advertising. But what about the old “you get what you pay for?” argument? Wrong. You think the fund managers pay top dollar when it comes to making their own investments? I thought not.

Has the fund outperformed its peers?

Obviously, this is key. I don’t need the fund to outperform each and every year. But I do want the fund to have a solid track record, leaving me with the impression that out-performance is a reasonable expectation. I focus primarily on quartile performance. A first-quartile performer has beaten at least 75% of its peers, a second-quartile has outperformed 50%, third has beaten 25%, and the dreaded fourth quartile jobs haven’t fooled anyone. A fourth-quartile return is about as useful as Ralph Wiggum at a Mensa meeting. Remember that Ralph eats paste and has an imaginary leprechaun friend who tells him to start fires.

As Miss Hoover once noted, “The children are right to laugh at you, Ralph.” Perhaps Ralph will grow up to manage a 4th-quartile mutual fund.  

I examine quartile performance across a number of different time frames (each year in the history of the fund, one-year, three-year, five-year, etc.) and like to see a lot of 1’s and 2’s. I’m not perplexed if the fund drops a 3rd quartile on me one year, as long as they follow that up with some goodness. If the underperformace continues, then I’m apt start looking around. Much depends on the market context and how the fund answers my other 4 questions. But in general, life is too short and I’m not there to support managers who aren’t getting it done. Besides, there are so many options out there. So you appreciate loyalty? Get a dog. Am I being too crusty? In any event…

Will this investment allow me to sleep at night?

When I go to Harvey’s and order an original bacon cheeseburger, I always make sure they add plenty of hot peppers. I like spicy food. However, beyond the modest portion of the portfolio dedicated to speculating, I’m not very excited about spicy investments; especially when it comes to my funds. Generally speaking, I tend to adopt a buy and hold strategy when it comes to mutual fund investing. Therefore, I don’t want to be always worrying about what the fund is doing and what the managers are up to. I don’t want to follow the daily price movements of the fund. I don’t care about its charts. I don’t care about its moving averages. Fun stuff to talk about, but I’m unlikely to ever use this information.

So how to assess peace of mind? I look at numerous measures of volatility. I’ll glance at the fund’s best performing period and worst-performing period, get a feel for how it performs in both up and down markets, and have a look at its beta analysis. Beta is a fund’s volatility measured against a specific index (e.g., the S&P 60), which has a set beta of 1. Here’s how you interpret the information: If a fund has a beta higher than 1, it means it’s moving up and down more than the rest of the market. Therefore, it’s more volatile. A fund with a beta of 1.5 will move up 15 percent when the S&P 60 rises 10 percent. Some of the pundits recommend looking at high beta funds when the market is going up and low beta funds when the market is going down. Fair enough, but this requires a crystal ball and some trading. I don’t have the first and I’m not interested in doing the second. Of course the pundits also generate such gems as “buy low and sell high.” So deep.

What’s the punchline? I gravitate to funds with relatively low beta’s. I’m prepared to miss out on some of the fun of a bull run, but I don’t want to get slammed very hard when things get ugly.

Is the fund relatively tax-efficient?

People rarely talk about this. But here’s the thing: Taxes matter! If an equity fund is delivering solid returns but has a high turnover, then much of the returns may be snatched away by the government. By recognizing the tax implications before you invest, it’s relatively easy to decide whether a fund belongs in or outside your RRSP. If you don’t have room in your RRSP or you’re done contributing, then why consider a fund that is brutal from a tax perspective? It’s considerably more challenging if you start thinking about taxes after the fact. does a thorough job of rating the tax efficiency of mutual funds and I rely on their numbers, even if some of the information they present is rather cryptic.

Looking ahead: Changes to

In a future edition of Market Guy, I’ll write about a number of funds that have made the cut and are in the portfolio. Using the five questions, we’ll see if these funds are still getting it done. Speaking of looking ahead, I’m considering making some adjustments to the site. Feature articles take a while to develop and my current workload makes it difficult to publish more than once a month. However, I have thoughts that I’d like to share between official editions. I’m considering maintaining a web-log (or blog, for those of you hooked up to the techie groove). The entries would be brief, but I’d be updating the site at least once a week. In fact, the blogs could be packaged into some sort of extra monthly edition placed in the archives. Just brainstorming here. As always, if you have any suggestions or feedback, don’t hesitate to send a note to

Trading note

I have eliminated my position in Advanced Fiber Technologies (AFT.UN on the TSX). Took a beating on this one after the fund unexpectedly slashed their distribution and the units took a dive. This fund is more spicy than many in the business trust universe, and I knew that going in. However, I was hoping for some growth in distributions…and received the exact opposite. The warning signs were in the quarterly report delievered in August. Declining margins, increased competition from OEM’s, and a drawing down of their cash reserves all meant trouble. I was so busy with moving into the new Market Shack and getting ready for the fall term that I failed to read the report. If I had, the units would have been sold right away. Basically, there is a fine for being dumb and I just paid it. Call it the Dumb Tax.

Although a cut in distributions seems to be the prudent move, many have been caught off-guard by the size of the cut. The company wants to play it conservative and I can appreciate that. However, that doesn’t mean I’m going to keep money in harms way. One commentator suggested that perhaps the “smart money” (whatever that is), would regard the drop as a buying opportunity. However, I’m looking at it from a different perspective. Who says AFT’s business situation is going to get any better? So, I’ve decided to move on and book the tax loss. The trusts have been so rewarding that a tax loss will do some good when filling out next year’s return (what you call “rationalizing”, I’ll call “seeing the glass as half-full”). In any event, I’ve reviewed all of my remaining trust holdings and feel good about stability of distributions. I’ll put together an update soon.

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. The title of this edition borrows from the 80’s pop duo, Hall & Oates. Ah, Maneater, Private Eyes, Kiss On My List, and my personal favourite, Out of Touch. You’re never out of touch when you’re with