Blessed by the Potato

Ben asked a question about mutual fund fees. That’s somewhat fortunate, as that’s something I just did a bit of research into. It’s somewhat unfortunate since it’s a slightly advanced topic to jump into with “part one”, so I’ll drop my numbering scheme now :)

To briefly cover the background, mutual funds are a collection of stocks, bonds, and cash (sometimes a mixture of all 3, sometimes just stocks) that an investor can buy into. Stocks generally have the best returns over the long term, but can be quite risky. One of the best ways to try to reduce the risk is to diversity into many different stocks, both amongst different individual companies and in companies in different sectors. There are many different rules of thumb about how much diversification one needs, but generally 10-25 different stocks are recommended. I haven’t seen anyone recommend more than 30, since beyond that there isn’t much risk reduction (at that point you should have enough companies and sectors sampled that the only way you’d face significant loss is if the market crashed as a whole), and there becomes a nearly unmanageable amount of data to follow. In addition to the administrative task of following all those stocks, it requires a lot of money to do: each purchase will have a broker fee, and to not have those fees eat up any potential profit, one needs to invest a fair bit in each stock (and that’s not even getting into issues like odd lot trades).

Mutual funds can pool the money from a number of investors and buy a whole crap load of stocks (and bonds, and hold cash). This can free one from the day-to-day stress of watching the market as well as providing a decent amount of diversification.

However, mutual funds often charge a number of fees that can sap their potential returns. There are “front-load” and “back-end” fees, which are basically transaction fees when you buy or sell, respectively. Many back-end fees are for a limited time only, designed to punish early redemption, and to keep people from trading in and out of a mutual fund too much. Of course, “early” can be subjective: some of TD’s mutual funds only have a 90-day lock in period, whereas others can be up to 7 years. Some funds don’t charge these fees (“no-load funds”), but all funds (even no-load ones) will have some sort of recurring expense to cover the cost of administering the fund, paying the managers to select stocks/bonds (if applicable). Advertising, kickbacks to salespeople/advisers, and legal fees are also included in this recurring expense. These recurring fees are called the Management Expense Ratio (MER) and are given as a percent of the fund’s value. The transaction fees/commissions to buy/sell stocks when the fund’s portfolio changes, or when more people buy in (or leave) are another factor, but according to the OSC’s site, aren’t included in the MER.

These MER fees are compounded annually, and you don’t get an invoice or a line-item breakout to see how much they’re costing you each year. They’re simply a negative added on to the fund’s overall growth rate. If the fund’s underlying portfolio of stocks, bonds, and cash went up 7% over the year, but the MER was 1%, you’d see a 6% increase at the end of the year. Likewise, if it was a bad year and the fund just broke even (0% growth in the portfolio), that 1% MER would actually cause you to see a decrease in the fund’s value of 1% at the end of the year.

Canada has some of the highest MERs on mutual funds around, with an average up around 2%. 2% on its own might not sound like much, but when “the market” goes up something like 10% a year in the long term, a 2% hit can be brutal. A mutual fund with a 2% MER, just to keep up with the market would need a gross appreciation of 12% per year (that is, they’d have to beat the market by 2%). It can be done, but usually it’s done only by luck or by the very best investors. I believe the statistic is that only 20% of funds manage to beat the market (or rather, the index they’re compared to) — the rest are either no better, or of course, worse. Also keep in mind that the power of compound interest applies to MER fees as well, though it’s negative in this respect (cutting your compound interest rate from 10% to 8%).

So, there have been some good arguments suggesting that rather than pay 2% to a mutual fund that will likely not end up beating the index it’s measured against, one should instead just buy the index. Some low-cost funds do just that, including the TD e-series funds. These funds are not managed: they simply blindly follow the index (S&P 500, Dow Jones, Scotia Bond Index, etc.) and have a minimal cost (MER of about half a percent — as low as 0.31% for the Canadian Equity index). These low-cost funds can be a great way to get some diversification for a larger portfolio, or form the beginnings of a small one (especially since the TD ones have a low minimum investment of $100).

There are reasons sometimes to pay higher fees. If you genuinely believe a fund will outperform the market (and some do) then that’s a good reason right there. For example, despite the fact that the energy and natural resources sectors are quite hot lately, I think concepts such as peak oil are only going to drive them up further in the future. However, TD doesn’t have a low-cost energy or resources sector fund available: both of those cost 2%. I think for those sectors, I might take the hit since they would be a bit of a gamble to begin with. Also, some RRSPs will only offer a limited selection of mutual funds, all at higher fees. To go out on your own might incur a cost of $100/year for a self-directed RRSP account, which for any portfolio under $5000 would be over the 2% the mutual fund would hit you up for. In those cases, the tax savings of an RRSP might save you.

Getting diversified into foreign stocks is also a great place for mutual funds to shine. Canada is only a small part of the overall world economy, so the argument goes that only a small part of your money should be in Canadian equities. But if you thought it was hard to research and monitor Canadian stocks, doing so on an international scale might well be impossible. So let a mutual fund do it for you. There are some low-fee ones (such as the 0.5% ones at TD) to track European, Japanese, or more broad-based global indexes. Otherwise, this might be a place where it would be acceptable to pay a little bit more.

Don’t however, get suckered into paying a high MER on a mutual fund just because the person at the bank or your financial advisor recommended that fund (or a list of funds). Often, these people will get commissions or kick-backs for selling mutual funds, so they may face a conflict of interest. Likewise, don’t pay it just because a fund is “popular” (you may just be paying for advertising then), or because it’s had good performance in the past. It’s difficult to predict the future, and sometimes past trends carry on… but it could also be that a fund just capitalized on a fad and is about to tank. You’ll need to do a little more research…

A final note is that exchange traded funds (ETFs) typically have very low MERs, it’s sort of their specialty. I’m still researching those after seeing Canadian Captialist talk about them, but I’m a little more in favour of the TD e-series funds. Partly because there’s no transaction fee, whereas I would have to pay a commission for buying/selling an ETF. Partly because the ETFs I looked at (some of the iShares ones on the TSE) were very thinly traded, so the funds were trading a fair bit above what their value would be in terms of holdings. And partly because it’s easier to buy in to the TD ones with very small amounts of money, incrementally. There’s no strict minimum (except for 1 share) for an ETF, but generally when buying shares one wants to go with a “board lot” or 100 shares, which can be a little pricey to start with, and difficult to add to over time. The $100 minimum (which can also buy fractional shares) for the TD funds is much more attractive.

Links:
Investopedia, diversification.
Ontario Securities Commission, mutual fund fees.
InvestorED Mutual Fund fee calculator
Canadian Captialist “Mutual Fund Fee Debate: The Industry Response”
Canadian Captialist “Top Five Reasons to Index Your Portfolio”
Canadian Captialist “Reasons to Avoid Actively Managed Funds”
Canadian Captialist “Two strikes against active management”

Disclaimer: I am not a financial advisor, and this post (or any other) is not to be construed as financial advice. In fact, I’m a graduate student, and thus have obviously made one of life’s worst financial mistakes and you shouldn’t listen to a thing I say. Seek the advice of a professional, and only invest what you can afford to lose in equities.

Sorry for all the talk about money and finances lately, I know it’s boring to some people. I promise to get back to hybrid cars, nuclear plants, copyright, and general all-out ranting and raving craziness soon. But first, a question: how much do you know about finances? I realize that most of the people who read this (at least, those who I know about and who comment) are students or young people in the beginning of their careers and moving-out-on-their-own lives. Thus they might not be (or feel that they are not) in a position to have significant long-term savings, and thus aren’t worried about how to manage those savings.

Nonetheless, knowing this stuff can be quite important, especially as our cohort comes to the age where savings is both possible and easily overlooked in favour of shiny things.

I take a lot of this stuff for granted, after all, my dad was an accountant/financial consultant, and passed a lot of it on to my brother and me (though I don’t know if he’s been teaching my sister). So I’m sometimes amazed at how little a lot of the general public knows about saving, investing, and finances in general. One example was a new student in our lab who, despite living on her own for years and being in university, did not have a chequing account for us to set up direct deposits for her. I had to explain why she needed to open an account, how cheques could be useful, etc. To be fair, she did have a bank account, an old one where she could go to the bank, in person, and withdraw or deposit money, and have the tellers pay bills. Why one of them never set her up with a more modern account I’ll never really know.

Similarly, there was some discussion recently about mutual fund fees, and how unaware many people are of them. That made me wonder how many people were aware of mutual funds at all? So I figured I’d put together a little list/quiz of sorts. Feel free to give your answers in the comments, or keep them to yourself… but please feel free to ask me if you’re not familiar with anything. I’d be happy to follow this post up with a blog entry on each, but don’t really want to waste my time if everyone already knows this stuff or will run off and learn about it somewhere else before I write it up :)

Are you familiar with/have:

1. A chequing account?
2. Online bill payments?
3. Savings accounts? (Especially high interest savings accounts)
4. GICs?
5. Bonds?
6. Mutual funds?
7. A brokerage account? (Online discount or otherwise)
8. Stocks?
9. Do you know about the power of compound interest? The exponential growth function? [Aside: I highly recommend that video series at least to part 3: At what point do you realize there’s a problem?]
10. Limit orders?
11. Risk? (Not the boardgame, though bonus points for people that do have the boardgame and want to play)
12. RRSPs?
13. Inflation?

There’s probably a lot of other things that could be added to a list like that (like “debt”), but that should do for starting discussion now…

As a gift for defending my thesis, a colleague and friend here got me a pen with my name engraved on it. I, being the pen-losing master, lost it in under 6 months. I was cleaning my desk today and found it again! Over a year later! …goes to show how often I clean my desk, though :(

I don’t know what’s wrong with me, but I seem to have lost the ability to cook recently. I tried making tomato soup last week. I made it the same way I do every time: can of Campbell’s tomato soup concentrate, a can of milk. Stir, heat, add oregano and basil, enjoy. Except along the way I curdled the milk somehow, turning it into threads of cheese in the soup. Ewww. Then this week, with a new carton of milk, I gave it another go, and did the same thing. I figured it was just tomato soup, so I tried Kraft Dinner: gross. I don’t know what went wrong exactly, but the whole thing just tasted terrible. Maybe the milk’s bad, even in the new carton, I figure, so I make a batch of pasta instead… ok, that was edible, but not really very good.

Then, just after blogging about how I have magical “innate frugal budgeting skills” I pull out the receipts from the last two months and crunch the numbers to see how close we came to being on-budget. For a total household budget of ~$2800/mo* (it’s not that exact; generally we aim for $2500, and don’t panic as long as it’s not over $3000), we managed to come damned close to breaking $4000 in October. There are of course a number of extenuating circumstances: there were a lot of sales on things that we stocked up on (hello, Coke through to next spring; ah, Halloween candy, my old love…), and being Halloween we managed to buy over $100 worth of decorations, spent $200 on our costumes, and something like $50 on food for the party. Plus I got new tires for my car, and we went out for dinner every week through the month (3 separate special occasions fall in October, so that’s only one or two random date night or meet friends eat-outs). While I don’t have the hydro or gas bill for November yet, assuming they’re the same as October then November will come in about $450 under budget (we only ate out once, I was sick, so we only drove to Toronto once, and we had a lot of groceries stocked up after October). Of course, December is going to be rough because of the gift budget… and the summer months were slightly over due to our Ottawa and cottage trips. Maybe I’ll need to get back to budgeting basics for the new year!

So today I’m feeling kind of dumb for losing the ability to do such basic things that came so naturally to me for so long…

* – just for the curious, we don’t actually live on $2800/mo. There are a few things, such as gifts and my curling membership, that through lack of a receipt or just plain forgetfulness never seem to make it into the budget reports. Those probably add $1000 or so for the year. Plus my parents help out a fair bit: we’re on the family’s car insurance, so my dad pays for that (which I’m told is very cheap for a car stationed in London), my dad pays for any dental work not covered by my insurance (and with two crowns this year, that is most welcome!), my dad says “take Wayfare somewhere nice” and will pay for a restaurant meal for us (which I tried to refuse at first, but hey, he’s got the stubbornness gene in full-force, whereas I only got one allele). That’s not even counting all the little things, like “borrowing” vacuum bags or movies from the ‘rents (I haven’t bought a DVD in 16 months). If I had to guess, I’d say our actual monthly budgets would come out closer to $3300 if we were really out on our own.

It’s crazy in Toronto this weekend, and this is also my first chance to test out my Nokian WRs in the nasty stuff (snow, then rain + ice).

I had heard that one downside to the tires was road noise, but even listening for it I could only say that it was noisier when taking turns or braking at slow speeds. Going in a straight line really doesn’t have any noticeable extra noise.

I’ve never had a set of dedicated snow tires before, so I can only compare these to all-seasons (most recently, Michelin RainForce MX’s). There is a quite noticeable improvement in snow and ice traction. On a road and a driveway that had turned to glare ice so slippery I slid down it after getting out of the car, there wasn’t much of a problem with the car stopping on it. The ABS did kick in, and the stopping distance was longer than it would have been on a dry road, but not nearly by the same amount as I would have slid in the all-seasons.

Snow grip seemed good, but one strange thing I noticed was that the car seems to decelerate more strongly in deep snow/slush than I was used to. There was no wheel spin when trying to get up to a start (using of course, gentle acceleration) from within deep snow. The car was pushed around a bit by wheel ruts, and when making a turn through that pile of snow left behind by the plow in an intersection. I was a little surprised at how much the car seemed to be forced into existing wheel ruts, but the snow was particularly deep (about 3″ on the road), very wet, and thus, very heavy.

After experiencing this, I don’t think I could go back to regular all-seasons. I think these tires are an excellent compromise between the grip of a proper set of winter tires, and the convenience of a single set.