Why invest in mutual funds?

Mutual funds give you the services of high-priced money managers at bargain basement prices.You can spend $60,000 to build a well-diversified portfolio – or you can do it with a fund for as little as $500.Funds are the most convenient type of investment you can make – they’re available on almost every street corner.I’ve heard all kinds of excuses for not investing in mutual funds.“They’re too risky.”“I don’t understand them.”“They’re too expensive.”“I tried it once and lost money.”“The sales people use too much pressure.”

“They’re a fad.”

In specific cases, each of those arguments could be valid. It’s certainly true that some funds are high risk, that some cost too much, and that some have a flavour-of-the-month aura. But to focus in too tightly on the flaws in mutual funds is a classic example of missing the forest for the trees.

Mutual funds offer advantages that a small investor simply can’t find anywhere else, which is why they’ve become so popular. Here are the key benefits:

Professional management. The people who run mutual funds are professional money magers, usually with impressive credentials and years of experience. That doesn’t mean they are all good. As in any other business, you’ll find some managers that are brilliant, some that are mediocre and some that are downright inept.

The good news is that with mutual fund managers, it’s somewhat easier than in most professions to sort out the wheat from the chaff. The Canadian Medical Association isn’t going to tell you which doctors are great and which are incompetent, and there are no published figures on a surgeon’s percentage of successful operations last year. The Canadian Bar Association doesn’t publish a monthly won-lost record for trial lawyers.

But mutual fund managers have the results of their labours publicly displayed all the time. When the fund statistics come out each month, you can tell at a glance who has the hot hand and who is trailing the pack. 

Those statistics don’t tell the entire story, of course. But they provide public insights into a person’s ability that few other professions outside of pro sports offer, or would even tolerate.

The investment world has become immensely complex over the past 20 years. Very few people have the time, knowledge and inclination to build and manage a diverse portfolio of stocks, bonds, cash, and real estate. As a result, money management has become a large and growing business.

But hiring your own personal money manager can be very expensive. Usually, a professional won’t even consider taking you on as a client unless you have at least $100,000 to invest — some won’t consider less than $1 million. If you do have that kind of money, the fees can be expensive – usually 1 to 2 percent of your total assets under management.

Mutual funds provide the opportunity to obtain professional management even though you may have only a few hundred dollars available. In percentage terms, the price may be higher than you’d pay for individual attention. But the actual dollar amount will be low, because most people don’t have big bucks to invest. If you put $1,000 into a fund that has a management expense ratio of 2.5 percent, your actual annual charge for professional money management will only be $25.

If you think you can do better and save that fee, go to it. You don’t need this article.

Portfolio diversification. One of the main problems faced by small investors is that they don’t have enough money to properly diversify their holdings. To put together a well-constructed stock portfolio, for example, you’d need to hold shares in about 16 companies. Properly chosen, this would give you a position across about 80 percent of industry groups.

If you were to buy a board lot (100 shares) of each at an average price of $20 a share, that would require an outlay of $32,000. But that would only give you a basic stock portfolio. For proper balance, you’d need to add some fixed-income securities, such as bonds, and some money market funds to your mix. Total cost for a well-diversified plan: say $60,000.

So, what’s so important about diversification, you may ask.

Risk reduction, that’s what. Professional money managers have two main goals. One is to achieve above-average returns. The other is to ensure that, in the event something goes wrong, their clients aren’t hit any harder than is necessary.

That’s where diversification comes in. If you invest all your money in one stock and the company goes under, you’ve lost 100 percent of your assets. If you invest equally in two stocks and one collapses, you’ve lost 50 percent. If you spread the same amount among four stocks, you’ve lost 25 percent of your money. At 10 stocks, your loss drops to 10 percent. At 20 stocks, 5 percent.

That’s the advantage of diversifying. By spreading your risk around, you limit the damage if one security goes south.

Mutual funds, of course, do all this for you. When you buy units in a mutual fund, you’re buying a share in that fund’s investment portfolio. If you want to know exactly what that consists of, ask for a copy of the fund’s latest financial statements. They’ll tell you what assets the fund was holding as of the record date.

In some cases, there may be hundreds of individual securities within a portfolio. That degree of diversification isn’t necessarily a good sign; the more securities a fund owns, the more difficult it is for the manager and staff to keep on top of everything. Ideally, I prefer to see a portfolio of 25 – 50 securities. It gives me a higher degree of confidence that the manager has the fund’s investment policy under tight control and is able to carefully monitor everything in the portfolio on a day-to-day basis.

Variety. Only a few years ago, the mutual fund marketplace in Canada was very limited. But now there’s a vast array of products on the shelf. At lat count, there were more than 2,000 mutual and segregated funds on offer, and the total continues to grow.

This growth has been good news for investors, on several counts.

For starters, more funds means better choice. The chances of finding a fund that exactly matches your requirements are improved. As well, the range of investment options offered by funds has expanded. At the start of the ‘90s, funds specializing in emerging markets, high yield bonds, telecommunications, health sciences, Latin America, and technology were unknown in this country. Clone funds, that allow you to add to the foreign content in your plan, were not even dreamed of. Now as we embark on the 21st century, all these choices, and more, are available.

Further, more competition leads directly to better service and lower fees. When a few fund companies dominated the market, they could pretty well call the shots. Now that’s no longer possible. One example of the benefits of a more competitive environment: there was a time when investors were charged a mandatory 9 percent front-end load to buy fund units. That time is long gone — some organizations now actually pay you a rebate to invest with them.

Finally, a larger industry means a lot more analysis and information. When I first started to write about mutual funds in the late ‘80s — not all that long ago — there were very few books available on the subject and the business media virtually ignored the topic. Now, the press carries daily reports on the industry, mutual fund managers have become media stars, there are several newsletters devoted exclusively to fund investing strategies and there are half-a-dozen annual consumer guides being published on mutual funds. There’s no longer any reason to remain ignorant about mutual fund investing!

Convenience. Perhaps the biggest advantage mutual funds offer is convenience. They’re almost literally available on every corner. Walk into any branch of any bank or trust company in this country and you can invest in mutual funds. You can pick up the phone and build a portfolio from your home. You can order funds by mail. You can buy them on the Internet. If you wish, some fund salespeople will even come to your home and take your order in the privacy of your living room.

No other investment form has made itself so readily available to the ordinary investor. You need a broker to buy stocks or bonds. Investing in real estate is an immensely complicated procedure. Even GICs and Canada Savings Bonds aren’t as ubiquitous.

Profitability. There’s no guarantee that any given mutual fund will make money, of course. But, if you hold it long enough, the odds are heavily that it will end up in the black. Over the decade ending Dec. 31, 1999, only three of the 118 Canadian equity funds in existence over that full time period reported a negative average annual return. All the others made money — even though that period included the big stock market crash of 1997.

Of course, in some cases the return was less than you could have earned by sticking the money in GICs (7.1 percent a year on average over the decade). But in most cases, the funds did much better. The average diversified Canadian equity fund returned 9.6% a year, according to figures published by The Globe and Mail. The average U.S. equity fund spun average annual profits of 15.3 percent. For more conservative investors, the average Canadian bond fund returned 8.5 percent a year. Even ultra-conservative mortgage funds averaged 7.6 percent — half a point better than GICs.

So why invest in mutual funds? In a nutshell, to make money and reduce risk. Do you need any more reasons?

(Adapted from Making Money in Mutual Funds, by Gordon Pape. Published by Prentice Hall Canada.)