Every time markets bleed red, mutual fund investors and the media become much more price-sensitive. So it's no surprise that print media have featured a barrage of anti-fee articles. (See the National Post on December 6 and the Globe & Mail December 5 and December 9 articles.) Interestingly, Canada's two national papers have united in a recent Investors Group bash-fest in this Globe article and this National Post piece.
I agree with the broad message, which is to keep an eye on fees. Since fees are pretty transparent and easy to understand, they get most of the attention when trying to explain poor investor performance. But the media and the industry would do investors more good by identifying and trying to remove the handful of barriers to satisfying long-term performance.
Management expense ratio (MER) Many of the articles casually mentioned a 2.50 per cent MER figure as being average for Canadian mutual funds. Canadian mutual funds' dollar-weighted MER at the end of 2009 was about 1.90 per cent annually. Add in the effect of HST and we're probably looking at fees of 2.1 per cent per year. This doesn't discredit any fee-driven arguments generally but it's ideal to work with accurate figures.
Performance dilution Based on my observations from portfolio reviews of hundreds of investors, do-it-yourselfers and advisors use too many funds when constructing portfolios. Finding a skilled manager is no cake-walk. But when you find one, you don't want to dilute their potential to add value to your portfolio.
Portfolio managers with potential to outperform an index usually must be willing to invest differently than that index. But if you blend too many of these bold managers together into a portfolio, you run the risk of having a portfolio that is very index-like. This runs a higher likelihood of kicking out returns that more or less track an index with active management fees - which will doom most portfolios to long-term mediocrity.
Volatility drag You've no doubt scratched your head at why a portfolio's long-term performance hasn't quite lived up to expectations. It's likely that volatility drag is one of the big culprits.
This is a very real factor explaining the gap between published performance and actual investor returns. The higher the volatility, the larger the volatility drag. And the larger the volatility drag, the wider the difference between published returns and investor performance.
If a mutual fund reports a 7 per cent 10-year rate of return, for example, the only way to have achieved that precise result was to invest at the beginning of that period, hold for the full decade and have no buys or sells in between. But few people fall into that category.
The investment industry has long preached the benefits of investing a regular dollar amount so that you buy more units of a fund when the price goes down and fewer when it's up. This intuitive argument just doesn't hold.
Volatility actually works against you when buying or selling on a regular basis. Balanced fund investors might see performance that is 40 to 50 basis points annually less than published figures over a long period of time. Stock fund investors, however, might see returns that are 150 basis points (or 1.5 percentage points) less than published performance just from the fact that there are regular transactions over time.
In other words, periodic investing is a good idea because it's a convenient way to save systematically. But make no mistake - it's a more costly way to invest because the volatility usually reduces percentage returns of regular contributors.
Poor timing This cousin to volatility drag is a more frequently documented effect that can only be measured in hindsight. Whether you bought into funds after posting triple digit returns or sold out of a fund that sported deep double-digit losses, time usually provides you with the perspective needed to see where your timing went wrong.
Again, the higher the volatility the more likely it is that investors will be lured into an investment at the wrong time - and repelled by its poor performance just before a rebound.
The sum of poor timing and volatility drag explain the full difference between published returns and investor performance.
Taxes & inflation The impact of taxes varies widely from investor to investor. Mutual funds haven't been the most tax efficient vehicles. However, the good news is that we have greater access to -- and make more use of -- tax-free and tax-deferred accounts. And more funds are designed tax-efficient (though some are too costly). After-tax returns can be as much as 25 per cent lower than net pre-tax returns.
And even low inflation rates like 2 per cent per year can reduce real wealth by 18 per cent over a decade and 33 per cent over twenty years. So virtually any amount of inflation is more than material.
Improving return potential While I've discussed the above factors in a mutual fund context, every one of them applies to investors buying stocks and most other securities. Quantifying and adding the above factors results in a frightening sum. They can easily add to a performance drag of at least 4 per cent annually on a gross 10 per cent total return. It's worse for some investors.
The good news is that removing these performance hurdles - as much as possible - can go straight to investors' bottom lines. Long-term performance can be enhanced by, for instance, keeping fees reasonably low, holding concentrated fund portfolios, minimizing investor misbehaviour and using smart tax-cutting strategies. In other words, tilt the odds in your favour as much as possible.
Dan Hallett, CFA, CFP, is director of asset management for HighView Financial Group and a contributor to thewealthsteward.com. He has spent more than a dozen years doing research on investment funds, portfolio managers and financial markets. Formerly the president of Dan Hallett and Associates Inc. in Windsor, he is now responsible for manager research, portfolio construction and investment program design at HighView. Mr. Hallett has a Bachelor of Commerce degree from the Odette School of Business at the University of Windsor.