Monthly Archives: August 2017

What are Mutual Funds

Giving a speech at local Toastmaster club

One of the best financial instruments to get started as an investor are mutual funds.

How a mutual fund operates

An investment company solicits investments from many investors. Those investments can be  as small as $25 per month. This is what makes mutual fund so appealing, that it is within the reach of practically anyone who can put together a small amount of money.

The money collected is is used to make investments, generally of stocks, but also bonds and other securities. A professional mutual fund manager is the person in charge of making daily investments decisions.

Having a large pool of money allows the money manager to diversify into many investments. Small investors generally don’t have the capital to invest in hundreds of different companies. Also, small investors don’t have the time nor expertise to research hundreds of companies.

Different focus of mutual funds

Many mutual funds companies have different focus of interest. For example, some funds may invest in technology companies, other funds may invest in dividend paying stocks, other may invest is small stock. It is up to the investor to decide which of those investments philosophies he/she prefers and then buy the mutual fund which reflects that philosophy.

Advantages of mutual funds

One of the big advantages of mutual funds is the elimination or reduction of single stock risk. Those who once owned Nortel, Enron, or Blackberry are well aware of the single stock risk. Single stock risk exist when an investor can lose a significant amount of money because the single stock they own, has a big decline in price. By having hundreds of stocks, the single stock risk is greatly diminished.

Disadvantages of Mutual funds

However, mutual funds are risky and many of them could do so bad that they could be closed down. It is quite possible to lose 50% or more of your money when investing in mutual funds.

Another big disadvantage of owning mutual funds is their high fees. Canada has one of the highest mutual funds fees in the world. While you, the investor, are putting your money at risk, the mutual fund company could easily eat away more than 50% of your profit. It’s very important to make sure your fees are low. Most Canadian mutual fund charge between 2% to 3% in fees. This is outrageous, they should be ashamed of themselves, but is it also, the generally public faults.

Side note: I have a friend, who continues investing in expensive mutual funds because the mutual fund salesperson invited him to a nice steak dinner.

Look for low fee index funds

If you are interested in mutual funds, make sure you don’t pay more than 1% in management fees. There are many alternatives out there.

It has been proven over time that most active managers don’t beat the benchmark to which their funds are compared. For example, a Canadian mutual fund may be compared to the Canadian stock market index. Most mutual fund don’t beat their benchmark because of their high fees or because of many other mutual funds inefficiencies.

The solution to diversify your investment and pay a low fee is to invest in a mutual fund which follow the national index. For example, in Canada, I would invest in a mutual fund which follows the the Toronto Stock Exchange 300. In the US, I would invest in a mutual funds which follows the S&P 500. The fee for this kind of funds is generally 0.10% or less.

Historically the US market and Canadian market have grown at the rate of over 8% per year. If you subtract the index fund expense of 0.10% then you will be left over with a profit of 7.9% or more. This is a more interesting scenario than paying 2 to 3% in fees to a mutual fund a mutual fund manager.

Large-Caps, Mid-Caps or Small-Caps?

Teaching tango at University of Montreal

What the academics say

Ever since I have been reading finance books, I have been reading that Small-Cap stocks are more risky but they perform better. I see graphs and charts backing up these studies, so I decided to double-check. Is it true that Small-Cap perform better than Big-Caps?

I went to my favorite ETF provider and I looked for Big-Caps (VOO), Mid-Caps (VO), and Small-Cap (VB).

What my findings say

My findings did not corroborate the results of the academics. In fact, my findings contradict the research of the academics. Maybe the academics had different set of data, but I have to work with the data that is available to little investors like myself.

Here is a 5 year graph which showcases Large-Caps, Mid-Caps and Small-Caps.

I was not able to find a longer term comparison.

In the graph we can see:

  • Big-Caps going up 19.95,
  • Medium-Caps 15.81
  • Small-Caps 9.51

You might say that 5 years is not a long enough time frame to make a decision, and I agree with you, but the time frame in which an investor gets in and gets out is often random, dictated by his life circumstances, most of the time outside of his control. In any other 5 year period, the results could have been different. What the next 5 years will do, no one knows.

My conclusion

Maybe the academics are right, but I am not an academic, I am real person with real money. I have to go with the information and the tools which are available to me at the moment.

We don’t know which sector is going to do better or worse, we don’t know whether small or large caps will perform better. If we assume that in the long run, stocks are going to go up, then let’s buy a little bit of all of them. Let’s buy Large, Mid, and Small caps. When we retire, when we begin to withdraw money to sustain our lifestyle, then we can take a look and determine which on performed better.