Be a friend to the investment industry. Stay ignorant about fees.
Mutual fund companies and other investment firms certainly hope you do because they could soon be confronted by the greatest fee challenge they have ever faced. Returns from both bonds and stocks could be disappointingly low in the years ahead and, after fees, there may not be a lot left over for investors.
The case for low stock market returns was succinctly made in a recent article by Samuel Lee, an analyst with the independent research firm Morningstar. I featured the article in my daily blog, The Reader, because its thesis seems so plausible. Basically, Mr. Lee argues that what he describes as a "deleveraging process" – a slowing of the economy caused by a gradual paying down of personal and government debts – may limit stock market gains to 4 or 5 per cent for the next several years.
That's a U.S. perspective, but it's relevant here as well. Canada is not swamped by debt like the United States is, but our deficit is still large enough that the upcoming federal budget should be the toughest in ages. Individual Canadians have pretty much the same debt levels now as Americans did before their housing market crashed. It's not hard to imagine a period of household austerity ahead as these debts are paid down.
As for the U.S. economy, Mr. Lee said the two best analogies for what's ahead are the latter half of the Great Depression and Japan's lost decade. In that light, he argues, then U.S. stocks today look "worryingly overvalued."
Your stock market returns could well be on the low side in an economically tepid environment of low corporate profit growth, but your mutual fund fees won't be. The average Canadian equity mutual fund's management expense ratio is 2.45 per cent. Prefer to focus on the most popular funds? The average MER for the 10 most widely held funds in this category is 2.1 per cent. If we get 4 to 5 per cent stock market returns as Mr. Lee suggests, then you could be in a position of seeing your returns halved by fees.
Now, let's look at bonds. Interest rates are already near historical lows and there's not much room for further declines. Rates moving lower is what drives big price gains for bond funds. With stable rates, you collect the usual interest payments on the bonds in the bond fund and maybe a little more if you have a smart fund manager. If rates rise, your bond fund would probably lose money.
The outlook is for today's low rates to stick around a while, which suggests bond fund returns will largely reflect the interest rate on bonds. Let's see now – the five-year Government of Canada bond yields about 1.3 per cent, and a five-year bond issued by a financially solid company might get you between 2 and 3 per cent. Meanwhile, the average Canadian bond fund MER is 1.72 per cent and the 10 largest funds in the category cost an average 1.5 per cent to own. So much for the yield on that five-year Canada bond. It's going to be devoured by fund fees.
Do not count on the fund industry to lower fees if returns diminish, although this has happened in the past. Back in 2009, money market fund fees were chopped so that unitholders didn't end up losing money. Interest rates had fallen and fees as they were at some firms would have more than offset the interest paid on the short-term securities held by money market funds. The industry would have had a massive scandal on its hands if money market funds, a supposed haven, were allowed to sink into the red.
The lesson here is that mutual fund companies will cut fees only if absolutely necessary. That means it's up to you to take care of yourself. One option is to join the slow but steady migration to exchange-traded funds, which in their classic form are index-tracking funds that trade like a stock. ETFs, with their low costs, are a more frugal alternative to funds for both do-it-yourself investors and those who use advisers.
But there's no reason for cost-conscious investors to give up on mutual funds. Just remember to weigh two things when considering a fund – its fees and the possibility of low investment returns in the years ahead. Don't be the ignorant investor who lets his mutual fund companies make out better than he does.
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Investing tips for tough times
Morningstar Analyst Samuel Lee wrote in a recent article that the current process of "deleveraging," or recovery from overborrowing, will hurt investment returns in the years ahead. Here are four practical thoughts he provides for investors:
1) Lowering costs matters even more than before.
2) Buy and hold strategies won't re-create the returns you expect based on historical data.
3) With downside risk expected to be higher, buying overvalued assets can hurt your portfolio.
4) Defensive stocks, or those that don't depend on sustained economic growth, are a good idea.
Rob Carrick