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Why do mutual funds still exist?

If most mutual funds fail to beat that market, and Canadians pay the highest mutual fund fees in the world, why the heck are we still using them?

If you’re unfamiliar with them or just need a refresher, mutual funds are professionally managed investment funds that pool money from many investors in order to purchase securities (like stocks and bonds). Mutual funds are actively managed, which means that there’s a fund manager working away behind the scenes to call the shots and decide what the money should be invested in. The idea being the fund manager should be able to use their expertise to pick stocks that will outperform the market average.

Despite this, most mutual funds fail to beat the market. It’s not that they didn’t make any money, it’s that they didn’t beat the benchmark they were being measured against (like the TSX or S&P 500 Index). Not to mention that once you factor in the high fees investors are paying to own mutual funds (sometimes north of 2%), you could end up in a situation where your money would do nearly as well in a high-interest savings account.

Let’s take a look at why they’re so popular:

 

Banks and investment advisors profit off of the high fees

One of the main reasons mutual funds continue to exist and are so popular is because they’re a money maker for banks and advisors. Mutual funds have many fees attached to them such as management fees, operating expenses, trading costs, trailing commissions, and incentive fees. Occasionally there are also fees (like a back-end load fee) if you sell your mutual fund before a certain date, which is often not made clear to investors when they start investing.

A major downside is that you’re stuck paying these sales charges, fees, and expenses regardless of how the fund performs, even if the returns and negative. Which means that banks and advisors will profit from you being invested even if you don’t.

When you’re investing your money, it’s important to understand how the person (or service) investing your money gets paid, and whose interests they put first when they’re doing it.

If you’re talking to an advisor who’s only licensed to sell mutual funds and can’t offer you a better alternative, then turning you away is kind of like turning down a bonus. You can see how advisor loyalty could easily be torn between their own, their companies’, and their clients’ best interest.

Just remember, it’s up to you to stay informed, ask questions, and research low-cost alternatives like ETFs.

 

There’s not much transparency or consumer control

Fund holdings are only known to investors at certain points in time, and you don’t have any influence or control over specific investment decisions made by the fund manager. Because of this, consumers are often left wondering what’s going on with the money they invest.

The lack of transparency makes it hard to ask critical questions and to find out what you’re actually being charged in fees, because that information can be buried in the fine print or not disclosed at all. This is good for banks and their advisors, but far from ideal for consumers.

 

They’re convenient and easy to invest in

Mutual funds initially became popular in the 80s and 90s because they were a cost effective way to diversify your investments. You didn’t need lots of money to get started and it was something you could set up during a trip to your local bank, so it was convenient.

Mutual funds gained momentum because the banking system was set up for it. Banks were able to use their current distribution channels to “upsell” these funds. If you went to the bank to pay your phone bill, the teller would almost always ask you if you’d also like to set up a retirement account while you were there. Historically, people have known to be loyal to their banks and like the idea of everything being under the same roof (your chequing account, mortgage, investments, etc) – so it’s not surprising they gained so much traction. By 2013, it was estimated that half of US households owned them.

Mutual funds are simple and for some people, they can be a good way to start investing by setting up small, regular, automatic contributions. Not all mutual funds are created equal and there are certainly some lower-cost options that may be a good fit for some investors. The problem, like anything, is that it’s important to weigh cost versus value. Just because it’s what we’re most familiar with doesn’t mean it’s the best option.

 

Alternative to Mutual Funds

While Mutual Funds still remain one of the more popular options when it comes to investing, there are alternative options out there that can end up saving you thousands of dollars, and better yet peace of mind. See below for some of the prevalent alternatives:

Exchange traded funds (ETFs)

In recent years, ETFs have started gaining popularity and for good reason—low fees! It also didn’t hurt when Warren Buffett said that the average consumer is better off with index funds. ETFs are a collection of securities (like stocks and bonds) that track an underlying index (such as the S&P 500 Index). Most aren’t actively managed, and the point of them isn’t to beat the market, but to match it. It’s been shown that ETFs often perform better than mutual funds and charge significantly lower fees.

Many investors buy ETFs through self-directed investing accounts. You can use an online brokerage to open an account and place your own trades. While a much lower cost option, it does require that you place all your own trades and re-balance your own portfolio. You also can’t buy partial shares like you can with mutual funds, so you won’t be able to auto-magically contribute and invest $100 every week. You’ll have to buy exact shares (for example three shares of an ETF that cost $34.45 each).

There are lots of books, courses, and online resources that can teach you how to do this, but it is a more hands-on approach.

 

Investing with a robo advisor

If you like the sound of low-cost ETFs but don’t want to go the DIY route, and you want the convenience of being able to set automatic, low contributions, robo advisors are a great option.

Many Canadian robo advisors invest in ETFs in order to create diversified, low-fee portfolios. They handle all of the rebalancing and portfolio management for you, and many have a snazzy-looking app you can use to easily check-in with your investments. You can easily and quickly open an account online in less than an hour. Going this route is a great way to get the best of both worlds—low fees and a hands-off approach.

No matter what way you choose to invest, always weigh the costs you’re paying with the value you’re getting. And of course, make sure that it fits into your overall financial plan and goals.

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