How do mutual funds really work? At the ground level, they are diversified collections of assets, usually stocks or bonds — sometimes both — in balanced funds, picked for their ability to generate income and/or capital gains. The key word is “diversified,” for that is their distinctive advantage. They are usually actively managed to seize cheap assets on the way up and to dump overvalued assets on the way down. Good managers are opportunists, buying when markets are panicking and ducking by reducing vulnerable holdings when they see storms ahead. That, at least, is the theory.
But what do investors really get for the money? Does active management pay, compared to passive or non-actively managed index funds or exchange traded funds? And what do investors really get when they sign up for a bunch of stocks or bonds?
Here comes the reality check. There are two broad kinds of investment funds. The first are those that have large capitalization stocks like chartered banks and pipelines, big railroads and giant integrated oil companies. In Canada, those collections makes up the top 60 stocks listed on the Toronto Stock Exchange, the TSX 60. In the U.S. it’s the megacap stocks of the S&P 500 or the gigacaps of the Dow Jones Industrial Average. The second kind of investment fund is the hunter-gatherer small to mid-cap fund whose manager is tasked to find and buy promising companies on the way up. This is a much harder job than buying the already successful stocks that populate the TSX 60 and the S&P/Dow.
Mutual funds that buy the large cap TSX 60 shares wind up most of the time as so-called closet indexers. They have to have some bank shares, so they pick and choose among the big six (TD, Scotiabank, Royal Bank, CIBC, Bank of Montreal and National Bank) making small variations of maybe a little less BMO and a little more TD than the index. Then they pick at telcos with a little more BCE Inc. or a little less Telus or vice versa. They wind up as shadows of their indexes, loaded with winners at the top and losers and also-rans at the bottom. This is pretty neutral stock picking, but it can go very wrong. Recall the disaster of Nortel Networks, once a third of the TSX by value of its shares compared to all those on the exchange. Mutual fund rules tend to limit exposure of any one stock to 10 per cent of the fund. But naked funds tasked to replicate the TSX index were slaughtered when Nortel collapsed, ultimately in bankruptcy.
If you want to buy into a big Government of Canada bond fund, the only thing the manager will contribute is his potentially wise decisions on where to weight his bonds from short maturities of five years or less, if he fears rates are rising, to long maturities of 10 to 30 years if he thinks rates will stay down or not rise much. Bond investing used to be an occupation practiced in mornings at the office before an afternoon of golf. It’s harder now, but beating the broad Canadian bond index or its specialized long and short components is still tough. Few managers get it perfect. You can buy a bond index for the entire Canadian market or the broad U.S. market as an exchange traded fund. It will have fees of 30 basis points (there are 100 basis points in one per cent) or less or you can go for the managed fund with fees of several times that — say 1.5 per cent.
The more tightly defined the fund, say Government of Canada bonds with terms of 10 years and over or Swiss pharmaceuticals, the less input the manager can contribute. After all, you have already decided when he or she should buy. Paying a manager a lot to do a little makes no sense. You are better off to buy a low fee ETF focused on your sector or asset class. Moreover, focused funds have higher fees, perhaps because when they thrive, more investors pile in (usually after the party has ended). If you want to pre-select a market or sector, go cheap and save fees.
When you get into small and mid-cap stocks that populate the Russell 2000 index in the U.S. and the TSX Venture exchange in Canada, you are in a different game in which there are thousands of listed companies, some destined to thrive, others to fail. Managers earn their keep in this arena for they must do a lot of research. Just rebalancing holdings off the indices is meaningless. It’s the same for junk bond funds in which the vast market of non-investment grade or unrated corporate debt varies in quality from pretty good and just below investment grade to crap close to bankruptcy.
Managers of funds of outliers such as little companies that are solid but unable to grow and bonds of companies that never paid to have them rated (issuers pay for ratings — another problem for another time) need to do a lot of legwork. They also need to diversify a lot so that one or two bad picks do not ruin their portfolios. Scandals abound in the small to mid-cap arena because vigilance by the community of stock analysts and the press is light. Most analysts have better things to do than to follow Chinese gold miners listed on the TSX or yet another software startup on the Russell 2000.
The problem for small to mid-cap fund managers is to keep up with their holdings, which have to be numerous to spread risk if a few fail. The agnostic approach to mid-cap stock investing is to forget about beating the market and just buy a relevant index. For example, the iShares S&P/TSX Small Cap Index ETF has a 60 basis point management expense ratio, a fourth of a typical mutual fund management fee, and gives access to 227 small cap Canadian companies. By comparison, the large cap iShares S&P/TSX 60 Index has management expense ratio of just 17 basis points. It is automatically hooked up to the index and has very little to manage.
The idea that a manager worth his pay will forage to find good companies is appealing, but there are many hunters in the small cap forest. In this forest, managers meet at the same dog and pony shows companies put on to peddle their stock and suffer from herd instinct. Managers gang up on a small stock, buy it enthusiastically and run up the price. Then they can abandon it and watch the price collapse. Worse, some small cap blowouts have been the result of crooks and gullible fund managers. Among the worst: the gold mine with no gold called Bre-X Minerals Corp.; the Russian mafia-dominated bicycle and magnet maker YBM Magnex; and gun merchant Adnan Kashoggi’s pitch to gullible investors to sell stock in a venture to dig up gold in King Solomon’s Mines. You get a sense of what nonsense the markets offer
The time is to do research is before you buy. “You don’t know who’s been swimming naked until the tide goes out,” said the great investor Warren Buffett. Profit beats remorse every time.