Blessed by the Potato

Ben asked a question about mutual fund fees. That’s somewhat fortunate, as that’s something I just did a bit of research into. It’s somewhat unfortunate since it’s a slightly advanced topic to jump into with “part one”, so I’ll drop my numbering scheme now :)

To briefly cover the background, mutual funds are a collection of stocks, bonds, and cash (sometimes a mixture of all 3, sometimes just stocks) that an investor can buy into. Stocks generally have the best returns over the long term, but can be quite risky. One of the best ways to try to reduce the risk is to diversity into many different stocks, both amongst different individual companies and in companies in different sectors. There are many different rules of thumb about how much diversification one needs, but generally 10-25 different stocks are recommended. I haven’t seen anyone recommend more than 30, since beyond that there isn’t much risk reduction (at that point you should have enough companies and sectors sampled that the only way you’d face significant loss is if the market crashed as a whole), and there becomes a nearly unmanageable amount of data to follow. In addition to the administrative task of following all those stocks, it requires a lot of money to do: each purchase will have a broker fee, and to not have those fees eat up any potential profit, one needs to invest a fair bit in each stock (and that’s not even getting into issues like odd lot trades).

Mutual funds can pool the money from a number of investors and buy a whole crap load of stocks (and bonds, and hold cash). This can free one from the day-to-day stress of watching the market as well as providing a decent amount of diversification.

However, mutual funds often charge a number of fees that can sap their potential returns. There are “front-load” and “back-end” fees, which are basically transaction fees when you buy or sell, respectively. Many back-end fees are for a limited time only, designed to punish early redemption, and to keep people from trading in and out of a mutual fund too much. Of course, “early” can be subjective: some of TD’s mutual funds only have a 90-day lock in period, whereas others can be up to 7 years. Some funds don’t charge these fees (“no-load funds”), but all funds (even no-load ones) will have some sort of recurring expense to cover the cost of administering the fund, paying the managers to select stocks/bonds (if applicable). Advertising, kickbacks to salespeople/advisers, and legal fees are also included in this recurring expense. These recurring fees are called the Management Expense Ratio (MER) and are given as a percent of the fund’s value. The transaction fees/commissions to buy/sell stocks when the fund’s portfolio changes, or when more people buy in (or leave) are another factor, but according to the OSC’s site, aren’t included in the MER.

These MER fees are compounded annually, and you don’t get an invoice or a line-item breakout to see how much they’re costing you each year. They’re simply a negative added on to the fund’s overall growth rate. If the fund’s underlying portfolio of stocks, bonds, and cash went up 7% over the year, but the MER was 1%, you’d see a 6% increase at the end of the year. Likewise, if it was a bad year and the fund just broke even (0% growth in the portfolio), that 1% MER would actually cause you to see a decrease in the fund’s value of 1% at the end of the year.

Canada has some of the highest MERs on mutual funds around, with an average up around 2%. 2% on its own might not sound like much, but when “the market” goes up something like 10% a year in the long term, a 2% hit can be brutal. A mutual fund with a 2% MER, just to keep up with the market would need a gross appreciation of 12% per year (that is, they’d have to beat the market by 2%). It can be done, but usually it’s done only by luck or by the very best investors. I believe the statistic is that only 20% of funds manage to beat the market (or rather, the index they’re compared to) — the rest are either no better, or of course, worse. Also keep in mind that the power of compound interest applies to MER fees as well, though it’s negative in this respect (cutting your compound interest rate from 10% to 8%).

So, there have been some good arguments suggesting that rather than pay 2% to a mutual fund that will likely not end up beating the index it’s measured against, one should instead just buy the index. Some low-cost funds do just that, including the TD e-series funds. These funds are not managed: they simply blindly follow the index (S&P 500, Dow Jones, Scotia Bond Index, etc.) and have a minimal cost (MER of about half a percent — as low as 0.31% for the Canadian Equity index). These low-cost funds can be a great way to get some diversification for a larger portfolio, or form the beginnings of a small one (especially since the TD ones have a low minimum investment of $100).

There are reasons sometimes to pay higher fees. If you genuinely believe a fund will outperform the market (and some do) then that’s a good reason right there. For example, despite the fact that the energy and natural resources sectors are quite hot lately, I think concepts such as peak oil are only going to drive them up further in the future. However, TD doesn’t have a low-cost energy or resources sector fund available: both of those cost 2%. I think for those sectors, I might take the hit since they would be a bit of a gamble to begin with. Also, some RRSPs will only offer a limited selection of mutual funds, all at higher fees. To go out on your own might incur a cost of $100/year for a self-directed RRSP account, which for any portfolio under $5000 would be over the 2% the mutual fund would hit you up for. In those cases, the tax savings of an RRSP might save you.

Getting diversified into foreign stocks is also a great place for mutual funds to shine. Canada is only a small part of the overall world economy, so the argument goes that only a small part of your money should be in Canadian equities. But if you thought it was hard to research and monitor Canadian stocks, doing so on an international scale might well be impossible. So let a mutual fund do it for you. There are some low-fee ones (such as the 0.5% ones at TD) to track European, Japanese, or more broad-based global indexes. Otherwise, this might be a place where it would be acceptable to pay a little bit more.

Don’t however, get suckered into paying a high MER on a mutual fund just because the person at the bank or your financial advisor recommended that fund (or a list of funds). Often, these people will get commissions or kick-backs for selling mutual funds, so they may face a conflict of interest. Likewise, don’t pay it just because a fund is “popular” (you may just be paying for advertising then), or because it’s had good performance in the past. It’s difficult to predict the future, and sometimes past trends carry on… but it could also be that a fund just capitalized on a fad and is about to tank. You’ll need to do a little more research…

A final note is that exchange traded funds (ETFs) typically have very low MERs, it’s sort of their specialty. I’m still researching those after seeing Canadian Captialist talk about them, but I’m a little more in favour of the TD e-series funds. Partly because there’s no transaction fee, whereas I would have to pay a commission for buying/selling an ETF. Partly because the ETFs I looked at (some of the iShares ones on the TSE) were very thinly traded, so the funds were trading a fair bit above what their value would be in terms of holdings. And partly because it’s easier to buy in to the TD ones with very small amounts of money, incrementally. There’s no strict minimum (except for 1 share) for an ETF, but generally when buying shares one wants to go with a “board lot” or 100 shares, which can be a little pricey to start with, and difficult to add to over time. The $100 minimum (which can also buy fractional shares) for the TD funds is much more attractive.

Links:
Investopedia, diversification.
Ontario Securities Commission, mutual fund fees.
InvestorED Mutual Fund fee calculator
Canadian Captialist “Mutual Fund Fee Debate: The Industry Response”
Canadian Captialist “Top Five Reasons to Index Your Portfolio”
Canadian Captialist “Reasons to Avoid Actively Managed Funds”
Canadian Captialist “Two strikes against active management”

Disclaimer: I am not a financial advisor, and this post (or any other) is not to be construed as financial advice. In fact, I’m a graduate student, and thus have obviously made one of life’s worst financial mistakes and you shouldn’t listen to a thing I say. Seek the advice of a professional, and only invest what you can afford to lose in equities.

Sorry for all the talk about money and finances lately, I know it’s boring to some people. I promise to get back to hybrid cars, nuclear plants, copyright, and general all-out ranting and raving craziness soon. But first, a question: how much do you know about finances? I realize that most of the people who read this (at least, those who I know about and who comment) are students or young people in the beginning of their careers and moving-out-on-their-own lives. Thus they might not be (or feel that they are not) in a position to have significant long-term savings, and thus aren’t worried about how to manage those savings.

Nonetheless, knowing this stuff can be quite important, especially as our cohort comes to the age where savings is both possible and easily overlooked in favour of shiny things.

I take a lot of this stuff for granted, after all, my dad was an accountant/financial consultant, and passed a lot of it on to my brother and me (though I don’t know if he’s been teaching my sister). So I’m sometimes amazed at how little a lot of the general public knows about saving, investing, and finances in general. One example was a new student in our lab who, despite living on her own for years and being in university, did not have a chequing account for us to set up direct deposits for her. I had to explain why she needed to open an account, how cheques could be useful, etc. To be fair, she did have a bank account, an old one where she could go to the bank, in person, and withdraw or deposit money, and have the tellers pay bills. Why one of them never set her up with a more modern account I’ll never really know.

Similarly, there was some discussion recently about mutual fund fees, and how unaware many people are of them. That made me wonder how many people were aware of mutual funds at all? So I figured I’d put together a little list/quiz of sorts. Feel free to give your answers in the comments, or keep them to yourself… but please feel free to ask me if you’re not familiar with anything. I’d be happy to follow this post up with a blog entry on each, but don’t really want to waste my time if everyone already knows this stuff or will run off and learn about it somewhere else before I write it up :)

Are you familiar with/have:

1. A chequing account?
2. Online bill payments?
3. Savings accounts? (Especially high interest savings accounts)
4. GICs?
5. Bonds?
6. Mutual funds?
7. A brokerage account? (Online discount or otherwise)
8. Stocks?
9. Do you know about the power of compound interest? The exponential growth function? [Aside: I highly recommend that video series at least to part 3: At what point do you realize there’s a problem?]
10. Limit orders?
11. Risk? (Not the boardgame, though bonus points for people that do have the boardgame and want to play)
12. RRSPs?
13. Inflation?

There’s probably a lot of other things that could be added to a list like that (like “debt”), but that should do for starting discussion now…

I don’t know what’s wrong with me, but I seem to have lost the ability to cook recently. I tried making tomato soup last week. I made it the same way I do every time: can of Campbell’s tomato soup concentrate, a can of milk. Stir, heat, add oregano and basil, enjoy. Except along the way I curdled the milk somehow, turning it into threads of cheese in the soup. Ewww. Then this week, with a new carton of milk, I gave it another go, and did the same thing. I figured it was just tomato soup, so I tried Kraft Dinner: gross. I don’t know what went wrong exactly, but the whole thing just tasted terrible. Maybe the milk’s bad, even in the new carton, I figure, so I make a batch of pasta instead… ok, that was edible, but not really very good.

Then, just after blogging about how I have magical “innate frugal budgeting skills” I pull out the receipts from the last two months and crunch the numbers to see how close we came to being on-budget. For a total household budget of ~$2800/mo* (it’s not that exact; generally we aim for $2500, and don’t panic as long as it’s not over $3000), we managed to come damned close to breaking $4000 in October. There are of course a number of extenuating circumstances: there were a lot of sales on things that we stocked up on (hello, Coke through to next spring; ah, Halloween candy, my old love…), and being Halloween we managed to buy over $100 worth of decorations, spent $200 on our costumes, and something like $50 on food for the party. Plus I got new tires for my car, and we went out for dinner every week through the month (3 separate special occasions fall in October, so that’s only one or two random date night or meet friends eat-outs). While I don’t have the hydro or gas bill for November yet, assuming they’re the same as October then November will come in about $450 under budget (we only ate out once, I was sick, so we only drove to Toronto once, and we had a lot of groceries stocked up after October). Of course, December is going to be rough because of the gift budget… and the summer months were slightly over due to our Ottawa and cottage trips. Maybe I’ll need to get back to budgeting basics for the new year!

So today I’m feeling kind of dumb for losing the ability to do such basic things that came so naturally to me for so long…

* – just for the curious, we don’t actually live on $2800/mo. There are a few things, such as gifts and my curling membership, that through lack of a receipt or just plain forgetfulness never seem to make it into the budget reports. Those probably add $1000 or so for the year. Plus my parents help out a fair bit: we’re on the family’s car insurance, so my dad pays for that (which I’m told is very cheap for a car stationed in London), my dad pays for any dental work not covered by my insurance (and with two crowns this year, that is most welcome!), my dad says “take Wayfare somewhere nice” and will pay for a restaurant meal for us (which I tried to refuse at first, but hey, he’s got the stubbornness gene in full-force, whereas I only got one allele). That’s not even counting all the little things, like “borrowing” vacuum bags or movies from the ‘rents (I haven’t bought a DVD in 16 months). If I had to guess, I’d say our actual monthly budgets would come out closer to $3300 if we were really out on our own.

Out in the blogosphere (blagonet), a bunch of people are describing their financial mistakes and entering a contest by Canadian Capitalist.

I have several mistakes to talk about. Most recently, I was locked in indecision about what to do about a car. Mine had been stolen (twice!), had just had an expensive round of repairs, and was making funny noises. I had a significant amount of “negative affect” every time I drove it: knowing that it had been stolen, cosmetically damaged, and who knows what else was done to it, it just didn’t feel like my car any more. I spent a ton of time researching what to get next (you all know how that ends: Prius). At the same time, some of the income trusts I owned were bought out, and I found myself with some cash instead of stocks. I also got a scholarship, but managed to live as though I didn’t (for at least a few months), and saved up some more money. All of that cash went and sat in a PC Financial high interest savings account so I could get access to it on a moment’s notice in case I needed it for the down payment on a new (or new-to-me) car. To sell my car, I had to detail it, and once I detailed it I reclaimed it to a large extent. It became much easier to forget it had been stolen when there weren’t someone else’s muddy boot prints on the dash, etc. The noises, while worrisome, stopped getting any worse and just kind of plateaued. I came to realize that I didn’t need a new car, and that my old one probably still had a few more years of life in it. While I had sunk in more repairs than it was probably worth, that money was already sunk, and if I could go even a year before the next repair, I’d probably still come out ahead of the cost of buying a new one.

This was a very slow realization, and that whole time — over a year — my down payment sat as cash. That money, which to me is a substantial fraction of my savings, could have been working much harder for me if it was invested a bit better, though I did at least have enough sense to get a 4% return on it over that time. In fact, with the recent market chaos sitting on cash probably worked out to be a good thing. However, that was a serendipitous event. I didn’t even put in a tenth of the effort determining what to do with that money as I did researching which new car to get. Maybe I would have done the research and concluded to keep a cash reserve, or to keep that portion of my savings in a safe, low income place, but I never gave myself the opportunity to make that decision with eyes open. I just let it happen.

Surebeam was another mistake. That one goes a fair bit differently: my dad first came to me with this stock, and he thought the financial side looked good, but wanted my biophysicist opinion on whether their technology would work or not. I thought it would, but might have problems finding a market with so many people afraid of the N and R words (nuclear and radiation). We both invested fairly early on. We set price targets for it, and were on our way. It actually went up for a while. Went up impressively, and hit my sell target within a year or so. Of course, I didn’t bother to check up on my portfolio for a month or so, and then was out of the country and calling home to my dad when I found out. I didn’t trust the public internet computer in the hotel’s lobby, so I waited until I got home to sell. Then I had to unpack and catch up on some work (*cough* and regain my position on the Warcraft III ladder *cough*), and it was about a week or so before I bothered to check back in with Surebeam. It had settled a bit from its peak, and I figured I would wait and surely it would go back up… and the next thing I knew the company was delisted, bankrupt, and my investment was worth nothing. There’s plenty of blame to spread around for that loss, including the management.

The careful reader will also notice that here things could have been saved if I had just put the time and effort into keeping on top of my portfolio. Or if I had taken a chance on a public computer. Or had the good sense to put in a standing sell order for my price target, especially before leaving for vacation.

To say that I’m an amateur investor, or that it’s a hobby of mine is to vastly overstate my case. I invest in the stock market because I was raised to believe that there are much greater returns to be had there than can be found in a savings account, GIC, or government bond. Because money should “work” for me. But I don’t put enough time and effort into staying on top of it, and that has been my financial mistake. There are tools out there to help people like me stay on top of things, and I’m working on checking the status of my portfolio (and any relevant news releases/columnist articles/etc) daily, or at the very least weekly. I’m also starting to look into potentially taking advantage of mutual funds, which can help keep me better diversified and will have managers to stay on top of things. What might be ironic is that I do take the time to set a monthly budget and every month or two I go over all my receipts and bills and make sure I’m staying on budget. Yet I have a pretty good natural instinct for that sort of day-to-day financial stuff and staying out of debt, so I might not even need to (or at least not spend quite so much time at it) — being a frugal university student for nearly a decade might have something to do with that.

So to sum up, take the time to stay on top of your money situation. If you simply can’t, find investments suited to a hands-off style.

Edit: Just to try to clarify, I do think that a mostly hands-off buy and hold, wait and see type strategy is generally good… but hands-off isn’t the same as brains-off :)

All this time with a blog, and I haven’t really touched on personal finances.

My dad’s an accountant by education, and then became a financial consultant as he got more experience in the work force (though the subtle differences between a CA and a financial consultant escape me), opening his own business and then closing said business down and “retiring” early. Now, retiring here goes in quotation marks because my dad still works at least a little bit every day of the week. His nearly full-time job now is managing his retirement savings to make sure that the returns keep coming in sufficient quantities to make ends meet without having to dip into the principal, if that can be helped.

He got my brother and I interested in investing at a very young age; he shopped around for banks that were willing to do business with kids with respect, and sell them very low-minimum GICs. We set up my first savings/chequing account when I was 10, and he explained the value of tucking the money I had saved up from my allowance and gifts into a GIC to not be touched for a whole year to get even more interest around age 13. I think I had my first set of Canada Savings Bonds at 15, and he was helping us play the market before I went to university.

Unfortunately for me, while I had the head for everything he was trying to teach us about picking stocks, I just didn’t really have the interest or more importantly, the talent for the non-tangibles. As much as my dad will scour a balance sheet for earnings, market capitalization, cash on hand, and yield, he also pays attention to the overall market and psychology of a company. Even if a company looks good on paper, if it just has a bad reputation and isn’t going anywhere with its sales, the stock isn’t going to do well in the long term. Vice-versa, even companies with a mediocre balance sheet can really turn it around if the market is going in their direction. One example is those funny sandals known as “crocs.” They’re actually made by a Canadian firm, and that company flew more-or-less under the radar for a while. My brother and my dad saw how popular these ridiculous shoes were becoming, and decided to invest a little bit, something that’s come out well for them. I couldn’t get over the fact that they were ugly and had holes in them, and thought it would never go anywhere. In case you haven’t noticed, my brother does seem to have the head for this sort of thing, and certainly the interest, so he’s now on the career path to becoming a stock broker himself.

You can’t really avoid the stock market if you want to save and invest your money. I mean, you can but then you’ll be barely beating inflation with a 4% GIC (OK, 5.5% if you run out to Canadian Tire right now). My dad has never been much of a believer in mutual funds, partly because he’s better than many fund managers at picking stocks (and even the good fund managers are sometimes hampered by the momentum of a mutual fund or other rules), and partly because many mutual funds will sap your potential returns with various fees (though investing out in the wilderness on your own also has commissions). Somehow, that dislike of mutual funds got passed on to me, and so I’ve been investing pretty much soley in individual equities either on my own or with my dad’s help.

In the last few days I’ve started to really reconsider the value of mutual funds. I’ve been largely invested into income trusts, which with the lying Conservatives have become a bit of a minefield. So I’ve been trying to do this “diversification” thing. And it’s really, really hard to spread your investment around when you don’t have a lot to invest. Not being diversified has hurt a bit. There are the nice winners, such as Q9 Networks, which has grown by over 50% in about two years for me. But there are also real dogs, such as Surebeam, which looked promising at first, and then tanked all the way to nothing once it was revealed that the people managing the company lied and they didn’t have the lucrative contracts they said they did.

Another advantage of mutual funds is that you don’t have to keep a constant eye on the market, which is something that my dad does but I, until very recently, haven’t. For one thing, it was always a bit of a pain to try to keep track of things, and while looking up stock prices is pretty easy to do each night, I always had trouble remembering where I bought, so it was hard to keep things in perspective. Plus, it was stressful. It’s much easier to be a buy & hold investor when you’re not worrying your portfolio daily. The use of easy tools has helped me with that recently, things such as Google Finance. To also keep on top of things I’ve started reading various analysts, bloggers, and writers in the business section of the paper and online. One, themoneygardener, is linked over on the right.

I’ve also become more interested in my “investment portfolio” lately as buying a house and a car have become nearer and nearer goals. Lots of friends have been getting all grown up, with houses, jobs, and kids. I am, of course, still in grad school, but that doesn’t mean that Wayfare wants to wait another decade for that sort of thing, so we’ve got to be planning and saving now, and keeping one eye on the real estate market.

To put it briefly, the housing market is scary.

If I thought diversification was a problem with a stock portfolio, buying a house blows that completely out of the water. For many people, once you get a house, that’s pretty much your only investment for at least a few years. Of course, at the same time you don’t worry as much about a market downturn because real estate is pretty stable in the first place, and even if there was a housing crash, well, you still have a place to live which was the main point (unless you’re flipping houses, which no one I know is), and as long as you don’t have to move, you can usually ride it out. Sure, we “lose” money by paying “rent” instead of “building equity”, but it’s a lot less risky that way, and there are lots of good articles that point out that if you can live frugally and save the difference between what rent is and what a mortgage would cost, that you can come out ahead of the game. Especially if it means you then save enough to put a decent down payment on a house…

But the thing that’s really scary is how fast the housing prices are shooting up. Wayfare tells me it’s 9% a year in London, and it looks to be about the same around Toronto (of course, a house in London costs about 50-75% of what an equivalent one in Toronto would). A friend just recently bought a house after saving and saving and saving for years to try to get a respectable 20% down payment. He tells me though that he couldn’t do it, and had to buy because he couldn’t even keep pace with his savings, let alone build on them, and had to get one of those 5 or 10% down insured mortgages. The housing market was simply growing faster than any other investment he could make. That renting and “saving the difference” argument really only applies to a relatively stable market, not one that’s shooting off like crazy like this.

For a long time now, I’ve looked at the real estate boom and consoled myself that it’s really a much better decision to stay out of it: I simply don’t have enough certainty about what I’ll do after I graduate to be buying real estate anywhere, and surely that kind of growth can’t be sustainable. I looked at the US, and read the market analysts, many of whom have long been predicting the “subprime meltdown” we’re seeing now. I looked at the demographics, and saw a lot of baby boomers coming up on retirement: to me, that looked like a lot of excellent family homes that might soon come up for sale as they decide to winterize their cottages and retire outside the city. From all of that I concluded that housing prices must stabilize soon, and maybe even correct downwards a bit.

It’s been over 2 years of saying that to myself now, and won’t we be damned, but the subprime crisis is hitting the States, but the Canadian market seems completely immune to it (well, except for our banks), much as it may bedevil me. My own parents (baby boomers), despite spending upwards of 50% of their time at the cottage have no intentions of selling their Toronto home, even with one son gone, the second on the way out, and the final kid applying to university next year, with out-of-town schools ranking high in her preferences. So much for my theory about a flood of baby-boomer homes coming up for sale.

I’ve had some rough luck in the market in recent years, and the markets in general aren’t doing too well lately, either. There have been some nasty capital losses for me, but thanks to the high payout of some of my income trusts my average return is still around 6%. While that is better than sitting on a savings account, that’s not a lot of return for the risk I’m exposed to. It also seems to be a low rate of return. I don’t really have any mutual fund literature that says they can do better or anything like that, but I have read a lot of investing articles that say things like “compounded at 8% over…” which seem to imply getting an 8% return is common and easy (in fact, I think that’s closer to what my dad averages). Heck, my landlord has to pay me 6% on my last month’s rent down payment. Of course, once you compare my 6% figure to the 9% the housing market has gone up, and I start thinking bad things about my ability to ever buy a house in the future.

But hey, the slight downturn the stock market is facing now may present some “buying opportunities” so that I can at least aim to be a rich renter (as much as it may irk Wayfare to “waste” money that way).