Choosing Mutual Funds: Are iUnits and iShares the Ultimate Solution?

There has long been debate over active and passive management – is there any value in active management? If so, how much return does active management add? If not, why do people buy actively managed mutual funds? Wouldn’t buying iUnits and iShares be the ultimate investing solution?


The Theory

Depending on which study you read (and there are a lot of them) you will get varying answers. If you want my opinion (please stop chuckling) I’d have to conclude there is no definitive answer to any of these questions. Luckily enough, for the average investor, the answer to these questions is not really that important. Let me explain why...

A couple of years ago, our firm was commissioned to analyze the universe of F-class mutual funds, iUnits and iShares (ETFs – Exchange Traded Funds) in order to produce portfolios with the best risk/return characteristics we could come up with. In my original hypothesis I assumed portfolios of all ETFs would produce the very best portfolios because of the ultra-low MERs associated with these securities. After weeks of analysis using proprietary software that mixed and matched the universe of Canadian mutual funds and ETFs together in millions of different combinations, we found the best portfolios were actually combinations of both managed mutual funds, and ETFs.

At first, we were a bit perplexed. How could managed mutual funds give a portfolio a better risk/return ratio than portfolios made up of only ETFs? As it turns out, there’s a very simple reason.

Morningstar released a report some months ago in which they reported managed mutual funds that consistently out-performed their benchmarks, also tended to have a lower R-squared value.

What’s R-squared? R-squared is a number between 0 and 100. The number defines how much of a mutual fund’s returns are due to market fluctuations. In other words, R-squared is a good measure of how much of a correlation there is between a mutual fund’s returns and the returns of the benchmark the fund is compared against.

Why did Morningstar discover managers with lower R-squared numbers tended to have better returns than managers with higher R-squared numbers? There are probably a number of reasons, but I would suggest the following: the higher a mutual fund’s R-squared is, the closer that mutual fund is to mirroring the index (otherwise know in the industry as ‘closet indexing’). Because of the management fees charged in actively managed mutual funds, the more a fund manager closet indexes, the harder it is for the manager to keep up with the index returns. For example, if a closet indexing fund manager’s mutual fund had an R-squared of 100, the fund would have a return equal to the index return minus the management fee.

If all investors had to choose from were ‘closet indexing’ mutual funds with 2.5% MERs, and ETFs with 0.8% or lower MERs, the choice would be very simple; buy the index and forget about managed funds. The problem with making this broad assumption is accounting for managed mutual funds with low R-squared. These funds sometimes differ so greatly from the indexes they are measured against, one could argue, they should be measured against a completely new index. But since there is no closer matching index to choose from, the best an investor can do is to invest directly in the low R-squared managed mutual fund if they want exposure to that management style.

So why were low R-squared, high MER managed mutual funds showing up in our analysis?

Very simply, the universe of management styles covered by all ETFs was smaller than the universe of management styles when managed mutual funds were also considered in the analysis. Some of the managed mutual funds were managed so differently from the index they are measured against, it was like adding a completely different index to the analysis. Bottom line: the managed mutual funds often diversified the overall portfolio risk enough to more than off-set their considerably higher MERs.


The Reality

OK, so now we know that in theory, the best portfolios are combinations of indexes and low R-squared managed mutual funds, but what happens when we apply theory to real life? Mutual funds can be purchased for free (minus the embedded MER of course) so if low R-squared mutual funds show up in a portfolio, we know all costs have already been considered. What about the index component of our portfolio? Are iUnits and iShares really as cost-effective an investment vehicle as we are led to believe, or would an investor be bettor off purchasing index mutual funds instead? The answer really depends on how much money an investor has to invest.

ETFs need to be purchased like a stock or bond with a commission cost on top of the ultra-low MER of the ETFs. This can make transparency of total costs for ETFs a little more cumbersome to figure out than for index mutual funds. Because of this extra cost, investors with smaller accounts may actually be better off purchasing an index fund with a higher MER instead of an ETF. Let’s look at a hypothetical example with numbers an investor should consider before selecting ETFs for the index portion of their portfolios:

Let’s assume we’ve created a mixed portfolio of three low R-squared mutual funds, and 3 indexes. Even if we buy the indexes through a discount broker, we can expect to pay around $40/transaction. If we assume we will rebalance our portfolio from time to time (at least once per year), we could reasonably expect to buy and sell ETFs in our portfolios at least six times per year. Therefore, we should assume we would spend at least $240/year in transactions for our ETFs.

We bought these ETFs to keep costs down right? Based on the MERs of comparable index funds (see table below), we really don’t want our yearly transaction costs to exceed 0.5% of our portfolio’s value invested in indexes per year. That means, with transaction costs of only $240/year, we would need to invest at least $48000 in ETFs to keep transaction costs to 0.5% or less. If we assume the ETFs only make up 50% of the total portfolio then the investor’s total portfolio size should be at least $84000 or more in value to make buying ETFs a good deal for the index portion of our portfolio. Any less money than that, and it might well be cheaper to buy index mutual funds instead.

Note: In this hypothetical example it’s important remember that if any of our transaction assumptions are too low, or if we purchase more than three ETFs we will need an even bigger portfolio to break even.

Now what about if a full-service advisor presents a fee-for-service portfolio to you either with all ETFs, or a combination of ETFs and managed mutual funds? As long as all of the mutual funds being purchased are F-Class mutual funds, an investor can safely pay up to 1% for equity funds and 0.5% for fixed income funds to the advisor without paying more than buying the regular retail version of the fund. Paying anything less than 1% for equity, and 0.5% for fixed income is generally a deal. Again, ETFs are different.

If the advisor is paying for all transaction costs of the ETFs out of the for-service fee, an investor again can safely pay up to around 0.5% of the accounts total value invested in indexes per year to the advisor and still be getting a slight advantage from the lower MER cost. If charged any more, the total cost of the ETFs will be approaching or even exceeding the cost of some index mutual funds (see table below). If transaction fees are charged separately from the for-service fee, then an investor will need to pay careful attention to their account size and the cost of transactions to ensure they can negotiate fees with their advisor low enough to avoid paying too much. If combined for-service fees and transaction costs cannot be negotiated down to under 0.5% per year for the index portion of a portfolio, an investor should consider index funds as a simpler, more transparent solution.

If total fees charged to the investor approach or exceed 0.5%, ETFs quickly lose their competitive cost structure advantage:

Canadian Indexes MER 1 Yr 3Yr

iUnit S&P/TSX capped 0.25 35.9% 24.4%
TD Canadian Index – I 0.88 31.1% 23.3%
RBC Canadian Index 0.78 31.0% 23.3%
National Bank Canadian Index 1.14 33.7% 23.0%
CIBC Canadian Index 0.96 31.0% 23.2%
Altamira Canadian Index 0.54 34.3% 23.6%

Canadian Bond Indexes MER 1 Yr 3 Yr

iUnit Broad Bond Index 0.30 4.4% 7.0%
CIBC Canadian Bond Index 0.96 3.8% 5.8%
RBC Canadian Bond Index 0.74 3.5% 5.3%
Scotia Canadian Bond Index 1.14 3.7% 5.7%
TD Canadian Bond Index – I 0.91 3.9% 5.7%


Conclusion

Although ETFs are very cost effective securities that should be considered for inclusion in an investment portfolio, it is a mistake to think ETFs alone, are the ‘ultimate solution’. Ignoring the vast universe of excellent managed mutual funds that can further diversify risk and increase overall portfolio performance clearly makes little sense. Compounded with the careful consideration to fees that must be paid to ensure account size is large enough to cover all commissions and service fees, ETFs are not always a good solution for every investor.

If an investor is planning to use a ‘buy and hold forever’ strategy, then purchasing ETFs through a discount or online broker is definitely a cheep, simple and effective way to get into the market. If an investor plans to rebalance their investment portfolio from time to time in order to lock in profits and dollar-cost-average into out of favour securities, or if an investor is dealing with a full service or fee-for-service advisor, much more careful research into all costs must be conducted by the investor. A combination of service and transaction fees can easily eat up all of the advantages provided by the low MERs of ETFs, leaving the investor with at best, the equivalent of index mutual funds, and at worst an overpriced, underperforming investment portfolio. However if investors do their research, and are careful to negotiate fees low enough, ETFs can make a very cost effective contribution to a well-diversified portfolio.

Providing problem member firms with the tools to improve sales compliance

(Forwarded by email to both the MFDA and IDA)


In January 2006, PureLogix Corp. released a new Internet driven software platform called Compliance Net. Compliance Net is designed to help branch managers and compliance departments of MFDA/IDA member firms more quickly and accurately identify and follow up on a number of compliance problems, currently including:

1. Unsuitable investments
2. Stale-dated Know Your Client data
3. Over-concentration in a single security in a client account
4. Accumulation of a security in multiple client accounts
5. Trades in unauthorized products
6. Churning in client accounts
7. Unilateral mutual fund substitutions
8. Listed Persons under U.N. Suppression of Terrorism Regulations to help combat the financing of terrorism
9. Suspicious transactions for Proceeds of Crime
10. Accounts held in non-cooperative countries and territories as determined by the Financial Action Task Force on money laundering

On top of automatically detecting the above mentioned compliance issues, Compliance Net is also live-linked to individual advisor portals. This gives advisors in the field an on-demand solution that not only identifies accounts that require attention, these advisor portals also give advisors the ability to double-check suitability of suggested transactions prior to the trade being presented to the investor. Clearly, MFDA/IDA member firms considering leasing Compliance Net will have big advantages over member firms that continue trying to detect and follow up on compliance issues by hand.

PureLogix Corp. has noted the IDA decision to assign a compliance monitor to help get Union Securities Inc. to comply with MFDA/IDA policy. We believe PureLogix Corp. could provide a similar service for the MFDA/IDA by providing Compliance Net for a member firm’s compliance department, advisor portals for advisors in the field, and an MFDA/IDA management portal for Compliance Net.

This management portal would be a powerful tool that would give the MFDA/IDA the ability to monitor sales compliance conditions at the problem member firm in real time. As the member firm started clearing the back-log of compliance issues, Compliance Net would automatically report the improving conditions to the MFDA/IDA, thereby reducing the need for more frequent audits, and as well as the likelihood of a firm ignoring MFDA/IDA compliance review recommendations.

I think you will agree, providing the MFDA/IDA with a live monitoring service would be an invaluable tool for the MFDA/IDA to gauge whether conditions are improving or worsening at a problem member firm. And from the member firm’s perspective, by being provided Compliance Net, there is now a capable tool and a reasonable game-plan for getting all branches into compliance within a very short period of time.

I’ve attached marketing material for your review. If the MFDA/IDA would be interested in viewing an online demonstration of Compliance Net’s capabilities, please feel free to call or email for an appointment.

Sincerely,

Edward Iftody
President
PureLogix Corp.

Regulatory Effectiveness

Will the MFDA back up its threats?

I think it’s fair to say, the financial industry is at an interesting crossroad. In the MFDA’s January bulletin, member firms were notified that MFDA staff is starting a second round of compliance examinations. In this second examination, the MFDA will be reviewing the various deficiencies they uncovered in their initial examinations at member firms. In the conclusion of the notice, the MFDA noted: ‘any deficiencies that were noted in the first examination that have not been rectified will be considered for referral to the Enforcement Department of the MFDA.’ The question is: what deficiencies will actually be referred, and how will the Enforcement Department handle the referrals?

The deficiencies found in the first examination were extensive, and in some cases, down right embarrassing. The MFDA found evidence of everything from churning and discretionary trading (issues that were immediately referred to the Enforcement Department of the MFDA), to simple but obviously critical issues like:

• Trade blotters not being reviewed regularly
• No evidence of follow up on issues discovered on the trade blotter
• Not maintaining a log of client complaints and/or not responding to client complaints
• No branch compliance reviews being conducted

After reviewing the ‘common deficiencies’ discovered by the MFDA, someone from outside the financial industry might reasonably ask, ‘since mutual fund dealers were monitored by the various securities commissions prior to the invention of the MFDA, how could these types of basic supervision issues be common?’

They are common, because prior to the MFDA, dealers were so rarely disciplined for such infractions. It’s hard for a dealer today to take these threats seriously. Although cheep, user-friendly technology exists to wipe out almost all of the more mundane day-to-day suitability and review problems pointed out by the MFDA, compliance departments have a tough time justifying the costs (or even the effort) to management, when the perceived threat is so low.

This lack of dealer motivation is not just an MFDA inherited problem. According to a BCSC’s 2002 audit of the IDA, ‘since taking sole responsibility for member regulation at IDA firms in 2000 (prior to 2000 the jurisdiction was shared by the CDNX, formerly the VSE), not only was the volume of proceedings not commensurate with the IDA’s new regulatory role, at the time of the report, the IDA had taken no action against firms in the previous 24 months.’ Even today, a review of discipline statistics on the IDA website shows an appallingly low number of investigations.

I’m not aware of the IDA releasing numbers from any audits they perform at member firms, but having personally been through a BCSC audit prior to the MFDA as well as an IDA sales audit, I can tell you the number of unsuitable investment cases randomly discovered by auditors makes the tiny number of complaints that actually get documented by COMSET look ridiculous. Why are the numbers reported to COMSET so low? Almost certainly because of the cost and effort required by investors to hire legal council to try and chase down losses. If you go into the IDA’s statistic page again, you’ll see another possible reason: the number of cases of investors that win arbitration are also frightenly low. In such an environment it is easy to see why dealers take these reviews somewhat lightly.

The IDA’s attitude appears to have changed little since 2002 in regards to suitability and supervision complaints. For example, someone not familiar with the financial industry might wrongly assume the IDA would consider fining a dealer for improper supervision when an audit detects a large percentage of randomly reviewed accounts containing unsuitable investments. Instead, the IDA issues a written notice to the dealer to ‘correct the deficiencies’.

Hey, I’m the first to admit, it’s a lot easier to deal with the handful of investor’s who lose their shirts each year to some crook than it is to try and stamp out all of the unsuitable investment problems before they happen. I’m sure it’s a lot easier to type up a deficiency report and walk away from the mess than it is to demand immediate action, but aren’t regulators in business to guard against such messes happening in the first place?

To be fair, I should point out both the MFDA and IDA are fining and banning obvious crooks in slam-dunk cases in which the advisor has simply stolen money from clients. But to be effective as protectors of the average investor, both regulators need to be far more proactive than regulators have been in the past. Regulators need to start fining incompetent advisors, and complacent dealers instead of just waiting for the investor complaints to roll in.

So, as I said before, we appear to be at a crossroad: what will the MFDA Enforcement Department do with the referrals it receives following this second round of reviews? Will the MFDA follow up on its threats and start issuing serious fines to make compliance with their policies and rules worthwhile from a business point of view? Will the increased pressure for positive headlines spur the IDA into doing more to protect the average investor? The MFDA notices look promising, as do the initial round of fines issued for serious rule infractions. But without follow-up, the threatening looking ‘bite’ will fizzle into an annoying small-dog ‘bark’ that can again be safely ignored by dealers.