Wednesday, October 31, 2007

Common Investment Traps: Back-End Loads

I enjoy talking about investing and have had discussions with a great many people with widely-varying investment knowledge. Over the next three days, I will be going over some of the common costly mistakes that people make in the course of investing with their financial advisors.

The first mistake is repeatedly getting hit with back-end loads on their mutual funds.

What is a back-end load?

A back-end load is a percentage of your investment that you pay when selling out of a mutual fund. Other names for this are “contingent deferred sales charge”, “redemption fee”, and “exit fee”. A common arrangement is for the mutual fund to charge 5% if you sell within the first year, 4% if you sell in the second year, and so on until the back-end load drops to zero after 5 years. In such cases, the fund typically does not charge a front-end load.

You may wonder how the fund could afford to eliminate the back-end load after 5 years if they had to pay the financial advisor at the beginning without collecting a front-end load. The answer is that the management expense ratio (MER) collected each year is high enough to cover the advisor’s up front commission if the money stays in the fund long enough. So, the mutual fund pays commissions out of either the MER or the back-end load depending on how long you stay in the fund.

How do investors get into trouble?

Many people feel vaguely uneasy about their investments, and some of them act on this feeling by periodically firing one financial advisor and jumping to another one who puts them into new mutual funds. Investors often do this without understanding back-end loads.

Suppose that impatient Ian switches financial advisors three times in 5 years paying a 4% back-end load each time in addition to a 2% MER each year. If he had an average of $200,000 invested over the 5 years, Ian would pay $20,000 for the MER, and another $24,000 in back-end loads. Ouch!

Sometimes getting out of a bad situation and paying the back-end load may be the right thing to do, but doing it repeatedly out of ignorance and impatience can be costly.

This is part 1 of 3 parts. Next part.

Tuesday, October 30, 2007

Financial Advisors

Many people have investments in the form of retirement savings. For Americans, this might be a 401(K) or IRA, and for Canadians, an RRSP. Often these investments have been set up by a financial advisor. I have dealt with many financial advisors over the years and have learned a few things.

1. Competence. Most financial advisors seem to be well-meaning people who don’t know as much as you might hope about investing. I’m sure that there are exceptions to both the well-meaning part and the competence part.
2. Main focus of the job. Their job is more of a mutual fund salesperson than what most people would think of as a financial advisor.
3. Individual Customer Attention. The comprehensive personal financial assessment that they perform with each client seems mostly geared toward figuring out how much they can get you to invest in mutual funds.
4. Conflict of Interest. The amount that financial advisors get paid varies from one mutual fund to the next. The funds they choose should be based on what is best for you, but some advisors choose the funds that pay them the most.

These comments do not apply to fee-based financial advisors who are paid for their time and do not receive commissions from selling mutual funds.

Are Financial Advisors Helping or Hurting People?

The short answer is some of each. Suppose that your financial advisor, Fiona, convinced you to set aside money for mutual funds each month. If you would have spent the money on shoes and over-priced coffee, then Fiona is helping you even though you may be paying high fees on your investments. However, in most cases, you could be invested in essentially the same investments for much lower fees. In this sense, Fiona is hurting you financially.

If you have managed to find a financial advisor who is knowledgeable about investing and serves your interests well, then you are fortunate because this is not the norm.

Monday, October 29, 2007

MERs seem low - why worry?

So what if the Management Expense Ratio that I pay on my mutual funds is 1% or 2% or 3%? If I’m planning to at least triple my money before I retire, why should such tiny percentages concern me?

The short answer is that the MER is collected on the same money year after year, which makes it really add up. The government may take one-third of your income every year, but at least they don’t tax the same money as income again. Imagine if instead of taking one-third of your income the government added up the value of everything you have and demanded one-third of that every year. “Let’s see ... your house plus the rest of your stuff is worth about $450,000. That makes your taxes $150,000 this year. Pay up.”

The MER is more like property taxes; you are taxed on what you have instead of what you make in a year. However, property tax rates are much lower than income tax rates. In my area, property taxes amount to between 1% and 2% of the value of a property each year. And at least the city takes my garbage away.

An Example

Suppose that your mutual funds charge a 2% MER. The rest of this will be easier to follow if you think of this as you getting to keep 98% of your money at the end of each year. After two years, you get to keep 98% of 98%. Pull out the calculator to multiply and you’ll find that you keep 96.04% of your money after two years. This is a form of compounding that works against you.

How bad does this get in 25 years? After paying 2% each year for 25 years, 40% of your money is gone. If you were expecting to have half a million dollars when you retire, $200,000 would be “missing”.

It might seem like the investment returns made by the mutual fund should be a factor in all this, but these returns don’t affect the percentage of your money that is taken in the MER. Whether the investments do well or poorly determines whether the MER is a percentage of a big pot of money or a small pot, but the percentage stays the same.

The MER is definitely not the only thing to look at when investing in mutual funds, but it is too important to ignore.

This is part 2 of 2 parts. Back to part 1.

Friday, October 26, 2007

What is an MER?

The people who run mutual funds have to eat. They also have to pay commissions to the people who sell units in mutual funds to the public. Other expenses include the cost of buying and selling stocks and paying for those slick commercials on TV scaring you into believing that you can’t do this investing stuff alone.

Where does the money to pay for all this stuff come from? Well, mutual fund managers could look for nickels on the sidewalk, but it’s easier to take some of the giant pot of investor money invested in the mutual fund. The percentage of investor money taken for these expenses each year is called the Management Expense Ratio, or MER for short.

A quick look through the Morningstar data on mutual funds shows that for U.S. funds holding at least $100M of investors’ money, the MERs tend to be around 1%. There is some variability, though. For example, the Vanguard 500 Index only charges an MER of 0.18% per year, while the Alpha Hedged Strategies Fund charges 3.99% per year.

In Canada, MERs tend to be much higher. According to the data, the average Canadian Equity Fund holding at least $100M of investors’ money charges an MER of 2.2%. This average drops to 1.9% when we weight it by the size of the fund. This means that big funds tend to charge lower MERs. Either way, Canadians pay a lot more than Americans.

As in the U.S., the MERs charged by Canadian funds tend to vary from fund to fund: for example, the iShares CDN LargeCap 60 Index Fund charges 0.15% per year, and the Trans GS Canadian Equity Fund charges 4.23% per year.

When mutual funds report their investment returns, the MER is subtracted first. This is good in one way because the reported returns are what the investor actually receives. On the other hand, this tends to hide the MER from the investor’s view. In the next instalment, we’ll discuss why investors should care about the MER.

This is part 1 of 2 parts. Next part.

Thursday, October 25, 2007

Why does my financial advisor seem to work for free?

One day at work I saw a sign advertising a free seminar hosted by my employer about investing and retirement savings plans. It just so happened that I was starting to think about putting some money away for retirement, and so I went to the seminar. An energetic guy named Mike gave a slick presentation with lots of graphs that I couldn’t completely follow, but I was left with the impression that Mike and his firm knew what they were doing, and that people could do very well financially by investing. Another plus was that my company’s employees would not be charged the usual yearly fees for Mike’s services.

I approached Mike, and we set a time for my wife and me to meet with him at his office. After some discussion, we agreed that we would invest in a couple of different mutual funds, but as we were getting ready to sign papers and hand over most of our savings, I had a strange feeling that something wasn’t right: we didn’t seem to be paying for Mike and his company’s services. The new accounts had no yearly fees, this meeting was free, we would pay no commissions on the mutual funds, the mutual funds we chose had no front-end loads, and we would only be charged back-end loads if we withdrew the money within 5 years.

When I asked Mike how he got paid for helping us, he managed to give an answer that steered me away without really answering. Slowly over the next few years of reading investment books, I managed to fill in the story. Mike and his firm got an up-front commission of 5% of our investment right away, and they later got a trailer commission of 0.5% of our money each year. These commissions were paid out of the mutual funds’ management fees and back-end loads, making them invisible to my wife and me. The exact percentages may vary from fund to fund, but the basic idea is the same: financial advisors usually get up-front commissions and, in some cases, trailers.

So, financial advisors do not work for free. Most of them just don’t like to talk about how they are paid.

Bonus: A Tax Rate of 93%!

I was going through some old papers belonging to family again and found the following in the 1963 Canadian Federal Tax Guide:

For the portion of income over $400,000, the tax rate is 80%. Add the Quebec provincial rate of 13.2% to this, and you get total tax rate of 93.2%!  The corresponding US tax rate in 1963 on income over $400,000 was close to 90% as well.

This really surprised me. Sure, $400,000 was an enormous income in 1963, but to take away almost all income above that level seems incredible. I used to think that income tax rates had risen steadily over the past century, but apparently, there have been some big bumps along the way.

Wednesday, October 24, 2007

What is a Mutual Fund?

I thought I’d jot down what I have learned about personal finance and investing over the course of several years of reading books and asking questions. It turns out that most of what is written on this subject is not useful and often seems designed to confuse and scare people. The truth is actually not very complicated.

A good example is the mutual fund. Many people own units of mutual funds in retirement savings without knowing much about them. Here’s a little story that is hopefully more useful than the usual dry definition.

What is a mutual fund?

We are bombarded with ads telling us to buy mutual funds. But, what are mutual funds? It’s a good idea to have a basic understanding of what mutual funds are before ploughing years worth of hard-earned income into them.

To start with, let’s go back to a time years ago when there weren’t any mutual funds. An average guy we’ll call Jim heard some good things about the stock market, got curious, and spoke to a stock broker about buying 5 shares of Buggy-Whips-R-Us. The stock broker seemed friendly at first, but when he asked if Jim meant 500 shares, Jim started to feel uncomfortable. The broker went on to explain that his company charges commissions whenever people buy and sell stocks, and that these charges would be nearly as much as the cost of the 5 shares Jim wanted. So, Jim left feeling small and foolish.

Undeterred, our hero had an idea. What if he got several of his friends together to pool their money? If ten people wanted to buy 5 shares each, they could spread out the commission charge on buying 50 shares. After the Buggy-Whips-R-Us stock went way up, they could sell all the shares and split the money.

So far, all I have described is an investment club, but we just need to add a few more things to get to the modern mutual fund.

Jim’s investment club was wildly successful and eventually grew to hundreds of members. They bought and sold many types of stocks and had fair rules in place to determine what fraction of the stocks each member owned. However, it became increasingly difficult for the members to agree on what stocks to buy and sell. Most members had little to contribute, but several members would argue fiercely. Jim realized that they needed an executive committee elected by the members to run the club and an investment committee chosen by the executives to choose the stocks to buy and sell.

As the club continued to grow, it controlled a lot of money, and Jim decided that the club could afford to pay a clever guy named Ted to do the stock picking. The idea was that a professional would make more money than the existing investment committee on the investments, and this extra money would be more than Ted’s salary; the members would make more money.

At first Ted seemed to work out well. It was hard to tell over a short time whether he was doing a good job, but Ted always explained his decisions to the membership and patiently answered questions. However, there were some rough periods, and Ted got nervous whenever the club discussed replacing him or going back to the old system of volunteer members doing the stock picking. Ted began to spend as much time protecting his job as he did on stock picking. He would take credit for the club’s stocks increasing in value even when it was just because the whole stock market had gone up and had nothing to do with Ted’s brilliance. Whenever the club’s stocks went down, Ted would talk about the current “difficult period in investing” and the “troubled waters” in these “turbulent and frightening times”.

Because working for the investment club was Ted’s full time job, he was able to put a lot more effort into achieving his goals than the volunteers on the club’s executive committee who had other jobs. Over time, Ted was able to increase his pay significantly, hire assistants, and control who served on the executive committee.

As the club continued getting bigger it became a mutual fund with the club members owning units in the fund. Ted’s role was filled by a company that specialized in money management, and although the mutual fund was officially being run by its board of directors chosen by the fund’s owners, in reality the club was being run by the money management company. Jim no longer had any meaningful say in how his club ran.

Fortunately, the government enacted laws to protect mutual fund owners. The management company has to make certain key information about investment style and risks available to new purchasers of mutual fund units, and there are rules about how the fund’s investment returns can be presented.

This story isn't literally how mutual funds formed, but it illustrates the basic idea behind mutual funds and the motivations of the various players involved.  Funds are a lot simpler than they might seem from looking at the vast array of information available about mutual funds.

Bonus: Help Wanted – Male

I was rooting through some old papers and came across the following ad that appeared in the July 31, 1964 Montreal Star:

I was struck by the obvious sexism and ageism: must be a male between 25 and 35 years old. The point is not to call out this newspaper or the company placing the ad, but to realize that this was an accepted common practice at the time. Although there is more work to do, we have come a long way in the last 43 years.

Tuesday, October 23, 2007

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