Smart mutual fund strategies

Investors are still shying away from mutual funds. The latest figures from the Investment Funds Institute of Canada (IFIC) show that in September redemptions exceeded new sales by $545 million. That reversed a positive trend that had been taking shape over the summer.

Canadians have more than $470 billion socked away in mutual funds. But the growth rate of the industry has declined considerably from the heyday of the 1990s.

The reasons for this apparent reluctance to commit new money to funds vary from one person to another but I believe that the number one culprit is the weak performance of many portfolios in recent years.

I have received numerous e-mails and letters from readers complaining that they lost heavily in the bear market of 2000-02 and are only now seeing their funds return to the values they were at in the late 1990s.

Natural reactions not always wise
There’s no doubt that bad results turn off investors, no matter what type of security is involved. When stock markets dive, people dump their shares. When interest rates are low, money market instruments and GICs get the axe; when they rise everyone sells thr bonds and bond funds.

These are natural reactions (although not necessarily wise ones) so it comes as no surprise that weak mutual fund performance would trigger the same results.

But before you turn away from funds, you need to work out a plausible alternative strategy. Socking everything into GICs is definitely not a solution. Interest rates may be on the rise but the returns offered on five-year money by the banks are still very low.

If you’re planning to build your own stock and bond portfolio, you need to have adequate capital for proper diversification ($50,000 at a minimum) plus you need to know what you’re doing. I received an e-mail recently from a couple who were learning about the market by investing in penny stocks. That’s an invitation to financial disaster.

Some investors have switched to exchange-traded funds (ETFs) as an alternative because of their lower management fees. I think ETFs, both passive and actively-managed, have a place in most portfolios. But an ETF portfolio contains the same type of risk and opportunity as one invested in mutual funds. Unless you invest properly, you can take a beating.

I think that mutual funds and ETFs continue to be the best choice for most investors, especially those with a limited amount of money available. The diversification and professional management these securities offer can’t be matched by most do-it-yourselfers.

However, to build a successful portfolio you need to use smart strategies that will keep your costs low and protect your assets in times of market volatility. Here is a list of the tactics I recommend; ask yourself honestly how many you are using. If your fund portfolio had been doing poorly, the odds are that you haven’t been following one or more of these basic rules.

Next page: The rules

Diversify, diversify, diversify. In real estate, we’re constantly told that the three most important factors in buying a home are location, location, and location. In investing, it’s diversification times three.

The investors who were most badly hurt in the bear market were those whose portfolios were top-heavy with equity funds. The people who maintained balanced portfolios suffered much smaller losses and perhaps even managed marginal gains because their profits on bond and income trust funds offset the declines on the equities side.

One of the axioms of successful investing is never to take anything for granted. Even the most experienced professionals don’t get it right all the time. Sometimes stocks go down when they should go up or interest rates fall when they are expected to rise. A well-balanced portfolio provides protection against the unexpected and will ensure that no matter what happens your capital will never be unduly exposed to risk.

Choose funds based on your risk profile. You can’t invest properly unless you know who you are. Among other things, that means understanding how much risk you are prepared to take. You must always look at the worst case scenario and make sure you are prepared to cope with it. The bear market that began this century was a classic example; many people were convinced it couldn’t happen and were blindsided when it did.

If you are a conservative investor, then for heaven’s sake choose conservative funds for your portfolio. On the equity side, managers like Kim Shannon, Jerry Javasky, and Gerald Coleman should be near the top of your list. Companies like Beutel Goodman have a well-earned reputation for taking a sound, conservative approach to money management.

Always check the style and reputation of the manager of any fund you are considering. If he or she is considered to be a financial gunslinger, don’t put your money in the fund unless you are willing to accept the inevitable volatility that will follow.

Keep your costs low. Sales commissions and management expenses eat up a significant portfolio of your profits. The less you pay, the more goes into your pocket.

Shop the no-load fund market first to see if you can build a satisfactory portfolio without paying any commissions at all. Some of the big banks have some first-rate no-load offerings, as do some of the boutique houses.

If you must choose a load fund, avoid deferred sales charge (DSC) units. They look attractive on the surface but you end up sacrificing flexibility. Many investors held on to losing positions through the bear market because they didn’t want to incur DSC charges on top of the losses they had already suffered. Ask advisors to buy front-end load units at zero commission for you. They’ll make their money on the trailer fees.

Pay special attention to management expense ratios (MERs). They have been on the rise, in some cases dramatically so. AGF American Growth Class, for example, has moved from an MER of 2.69 per cent in 2001 to 3.08 per cent today. That is way out of line for a fund of this type. Unfortunately, there are many similar stories in the industry.

Look at the boutique firms. There are exceptions but, generally speaking, the best combinations of high performance, reasonable risk, and low costs are found in the boutique fund companies, not in the behemoths that dominate the industry. These small firms don’t spend a lot of money on advertising and in most cases the minimum investment requirement is higher than for the mass-production houses. But if you have the money, this is where you should be looking.