Don't shy away from funds in your online account

With the freedom of an online brokerage account comes the responsibility of choosing smart investments.

Mutual funds, anyone? Many online investors consider themselves too savvy to buy funds, which they see as over-priced for what they deliver. But funds can work well in an online brokerage account, if you choose shrewdly.

Keep this in mind if you're one of the many investors who have set up an account at an online broker in the past year and you're struggling to get up and running. If exchange-traded funds and stocks are unfamiliar, think mutual funds for all or part of your portfolio. Note: if you're looking for guidance on which online broker to use, check out the Globe and Mail's 11th Annual Online Broker Rankings.

One benefit of using funds as a self-directed investor is that there is no cost to buy or sell them at many online brokers, while another is that you have the flexibility to mix funds from almost all fund companies.

Now for the down side of investing in funds through an online broker. Generally, you won't benefit from a lower cost of ownership because you're making your investment decisions and not using an adviser.

A little background on fund fees is called for here. Built into the cost of owning almost all mutual funds is a chunk of compensation for advisers and their firms. It's called a trailing commission and it typically accounts for 1 percentage point of the management expense ratio (MER) for an equity fund and 0.5 of a point on a bond fund on an annualized basis.

Trailers are meant to pay advisers for the work they do in helping clients. With a couple of exceptions, which we'll get to in a bit, online brokers also collect trailers. It's worth noting here that online brokers are strictly order takers and prohibited from offering advice. The most they can do is provide fund research tools and analysis on their websites.

The way to get around paying for advice you're not receiving is to invest in funds that pay either no trailer at all, or a small one. Calgary-based Mawer Investment Management doesn't pay any trailers, and neither does Steadyhand Investment Funds. Beutel Goodman, McLean Budden and Sceptre pay no more than 0.25 per cent, as does the Phillips, Hager & North D series of funds.

There are two benefits to dealing with fund companies like these, the first being that their fees tend to be much lower than average because they're paying little or nothing in trailers. The lower the fees on a mutual fund, the more left over for investors.

Second, these companies are rock-steady money managers that, in most cases, look after wealthy people, pension funds and endowments. They won't likely be chart-topping performers in any given year, but they're consistently solid and unlikely to surprise on the down side.

Many investors are still nervous about stocks after last year's dramatics and as a result they've become infatuated with bond funds. It so happens that the fund firms paying little or nothing in trailers are among the elite in managing bond funds.

Many of the major indexes have climbed recently, but analysts disagree about the strength of that recovery. What do you think?

Two good examples are Phillips, Hager & North Bond D, which delivered an average annual return of 5.5 per cent for the five years to Oct. 31 while its peers averaged 3.7 per cent, and Beutel Goodman Income, which made 6.1 per cent annually over the past five years.

The average MER for Canadian bond funds is 1.7 per cent, which compares to 0.59 per cent for the PH&N fund and 0.74 per cent for the Beutel Goodman fund. With fees this cheap, exceptions can be made to the rule that it's better to own actual bonds than bond funds.

We're not just talking here about conventional bond funds. Both PH&N and Beutel have specialty bond funds that specialize in high-yield bonds (PH&N) and long-term bonds (Beutel). Both also firms mix government and corporate bonds in their conventional bond funds, which provide a little extra yield and risk.

Here are some steps to take if you want to buy low- or zero-trailer mutual funds for your online brokerage account:

Check the minimum investment: Low-trailer fund companies typically have a minimum initial investment requirement ranging from $5,000 to $25,000. Often, you can reach this amount by spreading your investments among several funds in the same family.

Check for purchase or redemption fees: The online brokerage world is split between firms that charge nothing to buy or sell virtually all funds and those that charge up to $45 or so to buy and sell funds with little or no trailing commission. Consult your broker's website before ordering, or call.

Check the version of the fund you're buying: Many fund companies have a range of fund classes, each with a differing fee structure. Consult a fund company's website to make sure you're getting the right version. With PH&N and McLean Budden, for example, you want the D class.

Check to see if short-term trading fees apply: Funds aren't meant for short-term investing, but there may be a situation where you buy and then want to sell right away. Some brokers will charge you a fee of $40 or so if you sell a fund within a short period after buying. Some fund companies themselves have these fees.

Another option for avoiding trailers is to take advantage of features offered by a pair of online brokers, Questrade and RBC Direct Investing. Questrade's Mutual Fund Maximizer is a program under which clients pay $29.95 per month in exchange for having all fund trailer fees rebated back to them each quarter. Clients also have to pay $9.95 per fund trade. Fund Maximizer is considered economical with a minimum investment of $36,000 in funds.

RBC Direct Investing offers a D-series of Royal Bank of Canada's mutual fund family that has most of the trailer removed. For example, you could buy RBC Canadian Dividend D with an MER of 1.15 per cent, or the regular version at 1.7 per cent. A minimum $10,000 is required to invest in D-series funds.

If you're not troubled by paying for advice you're not receiving, then virtually the entire Canadian fund universe is available to you at most firms. You can base your entire portfolio on these funds, or just a part. Either way, funds are a legitimate portfolio building block for online brokerage customers. Don't let the stock jocks tell you otherwise.

Online brokers and mutual funds

Stocks and exchange-traded funds are obvious kinds of investments to use in an online brokerage account, but mutual funds can work well, too. Here is some information for investors who want to use funds in their online accounts.