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The search for low-fee investments

Smart purchasers are starting to eye cheaper, better performers, ROB CARRICK reports

What they don't tell you about fixing your funds portfolio:

After sinking close to half a trillion dollars into mutual funds, Canadian investors' long-running love affair is cooling. Their ardour has wanted, as the benefits of hassle-free investing and professional management are outweighed by high fees and underperforming returns. Smart investors ready to fix up their portfolios are considering such exit routes as exchange-trading funds and low-fee products from boutique firms. We offer a guide t some easy ways to tune up your investments.

Rick Clark used to have a portfolio stuffed with more than a dozen popular funds from several of the big mainstream companies. Then he did a little reading up on fees and how they were eating into fund returns.

"I just see [fees] as being way out of line," said Mr. Clark, a computer programmer with Nortel Networks in Ottawa. "The best way to indicate that is to vote with your feet, so that's what I did."

Convenient and practical, mutual funds are for many people the no-muss, no-fuss way to invest. Proof of their mass appeal? Canadians now have nearly half a trillion of their savings tied up in more than 5,000 different fund variations.

But mutual funds can be costly to own and their investment returns routinely underperform. Which is why it may be time for smart investors to start eyeing some options.

Mr. Clark still owns funds, but only ones with low fees.

Jim Steel's break with funds was more far-reaching.

Mr. Steel was a heavy user of mutual funds in his 11 years as a broker with a big bank-owned firm. Then he took the Chartered Financial Analyst course, a respected accreditation for financial professionals that exposed him to a theory saying it's very difficult for individual mutual fund managers and investors to beat the returns of the major indexes by picking their own stocks.

Now, Mr. Steel buys his clients exchange-traded funds, an increasingly popular alternative to mutual funds that provide the returns of a variety of stock indexes.

"Mutual funds are terrible investments in my opinion," Mr. Steel said. "They're just too expensive. You take a look at their performance and they underperform their benchmarks, plus there's hidden fees. I don't know why anybody buys them."

Funds are riddled with problems that aren't apparent to many investors. This week, the Report on Business series Mutual Funds: What They Don't Tell You has shown that Canada's fund industry has in some cases not served the best interests of investors. If it's not bloated fees that eat up returns, it's shoddy self-supervision that opened the door at many firms for highly questionable practices like market timing, where influential clients received special trading privileges that undercut returns for rank-and-file clients.

All this may tempt ordinary investors to conclude, like Mr. Clark and Mr. Steel, that it's time to stop being taken for granted by mutual fund companies and to fight back. But what are the alternatives?

Essentially, there are three: Buy your own stocks and bonds, get out of the fund industry's mass market mediocrity and into funds that combine low fees and top performance, or try exchange-traded funds.

For most fund investors, choosing individual stocks and bonds is impractical; it takes more time and knowledge than they have.

Mr. Clark went for the low-fee option. He sold his big-fee funds and moved into the likes of TD Bond, BMO Dividend, the Trimark Fund and three funds from the Saxon family, all of which have management expense ratios (MERs) that are way below average.

And it happens in the fund world that low fees and good returns often go hand in hand. Some prime examples: Phillips Hager & North, McLean Budden, Beutel Goodman, Saxon Funds, Chou, Mawer, and Leith Wheeler.

"I think that pretty well covers the ground for what I would pinpoint as being the really desirable boutique companies in Canada that fly beneath most people's radar screen," said Gordon Pape, an investing expert who has been rating funds for about 15 years. "They're all good. In fact, I own funds from many of them myself."

Low-fee funds aren't just a plaything of analysts and savvy investors like Mr. Camp. Some financial advisers also use them.

"We tend to pick funds where, as much as possible, they are low MER," says Warren Baldwin, a fee-only financial planner with T.E. Financial Consultants Ltd. in Toronto. "If we're doing a retail fund portfolio, an obvious example of what we'd use would be a family like Phillips Hager & North."

Mr. Baldwin says focusing on MER is critical because investors need to know what they're paying in order to decide whether they're getting good value. One way to do a quick value check is to use the mutual fund fee impact calculator offered by the Investor Education Fund Web site at http://www.investored.ca.

Be warned: It can be hard to find an investment adviser who sells low-fee fund families because they pay little or nothing in fees and commissions (that's a big reason why their MERs are low). To get an adviser on side, you may have to pay him or her a commission of 1 to 2 per cent of your investment. Discount brokers and fund dealers usually sell these funds, but they may also charge a small upfront fee.

Scraping together enough money may also be a problem. Each of the fund families mentioned above has a much higher minimum upfront investment than the average fund company's $500 or $1,000. PH&N requires $25,000, although you can spread that into several funds that can comprise a balanced portfolio. Saxon and Mawer are on the low end at $5,000, while Leith Wheeler requires a minimum of $50,000.

The high minimum investments are part of a corporate culture of frugality at these fund companies that results in MERs that are generally way below industry averages. By screening out multitudes of small accounts, administration costs are reduced. Most of these companies do almost no marketing and, as noted, they pay next to nothing in commissions to dealers and advisers.

The small fund companies mentioned earlier excel in most cases, but a few heavyweight companies with low investment minimums do reasonably well, too. Among them are Franklin Templeton and Fidelity, as well as three bank families -- BMO Investments, RBC Asset Management and TD Asset Management.

Funds from these and other companies that represent good value include: Canadian Equity: RBC O'Shaughnessy Canadian Equity, ABC Fundamental Value, PH&N Canadian Equity, Saxon Stock Canadian Dividend: PH&N Dividend Income, Scotia Canadian Dividend Canadian Bond: PH&N Bond, Beutel Goodman Income, McLean Budden Fixed Income, Legg Mason Canadian Active Bond Canadian Balanced: CIBC Monthly Income, RBC Monthly Income, McLean Budden Balanced Growth, Trimark Income Growth (SC version) U.S. Equity: Chou Associates, Mutual Beacon Global Equity: Mackenzie Cundill Value, Mackenzie Cundill Recovery, Saxon World Growth, Trimark Fund (SC version).

It's worth noting that some fund families that offer solid value also distinguish themselves in the area of governance. For example, both PH&N and TD Asset Management have tried to discourage market timing by levying fees on market timers who redeem money in the period just after buying.

Mr. Steel has dumped funds altogether and entered a long-term relationship with ETFs, which track dozens of widely followed stock indexes in Canada and around the world. Each ETF unit -- you buy them on stock exchanges -- represents a tiny holding in every stock in the underlying index, be it the S&P/TSX composite, the S&P 500, the Morgan Stanley Europe, Australasia and Far East Index and so on.

While it was investing theory that got Mr. Steel to think critically about funds, it was the real-world experience of looking at his clients' accounts that cinched his decision to move into index-tracking ETFs.

"I went back and I looked at the returns I was getting clients in mutual funds, individual stocks and wrap accounts," said Mr. Steel, who works at PWL Capital Inc. in Ottawa. "I couldn't say I was doing any better than the indexes."

The most popular ETF in Canada, the iUnits S&P/TSX 60 Index Fund, or i60 (XIU-TSX), has an MER of 0.17 per cent. A comparable large Canadian equity fund holding mostly blue chips would average around 2.4 per cent.

This means that you would make whatever the S&P/TSX 60 index does in a given year less 0.17 of a percentage point, or whatever your Canadian equity fund manager can achieve minus 2.4 per cent. Some managers will undoubtedly beat the index over a given period, but an indexing advocate would counter that it's too hard to predict which funds will outperform.

Index mutual funds sold by the banks do pretty much the same thing as ETFs, but at higher MERs that make them far less attractive. One exception is the e-fund series from TD Asset Management, which is available only over the Internet from TD directly or through on-line broker TD Waterhouse. You can get index funds that track major Canadian and U.S. stock indexes with MERs as low as 0.31 per cent.

One of the difficulties in making a clean break from underperforming mutual funds is the cost. If you bought your funds through an adviser with a deferred sales charge (DSC), and the vast majority of funds are sold this way, then you could be subject to redemption fees.

Most fund companies have a sliding fee scale that starts at 5 or 6 per cent in the first year and declines to zero after the sixth or seventh year. If you're trying to exit a few disappointing funds, you could easily rack up charges that drag your returns down even further.

Here are some options for getting out of DSC funds, supplied by Jack Di Nardo, an adviser with WealthWorks Financial Inc. in Richmond Hill, Ont.: The 10-per-cent rule: Most fund companies let you sell or transfer out 10 per cent of your holdings a year with no redemption charges. Some companies apply this percentage to your original investment, others to a more current valuation.

Switch to something better: It's often possible to switch to a better fund within the same family without triggering a redemption fee. For new clients with smaller accounts, Mr. Di Nardo would charge a 1-per-cent switching fee to cover the cost of his efforts in getting the switch done.

The commission rebate: The adviser sells the client's DSC funds and moves the assets into new funds elsewhere. He then takes his upfront commission for selling the new funds and uses it to offset the redemption charges on the old fund. Each dealer may have specific rules that discourage such transactions, Mr. Di Nardo said. "I'm willing to do this and I think there are a number of advisers who are, but I know that some people are very inflexible on this."

Mutual funds will always be the investment of the masses, if only because they're an easy answer for people without the time, knowledge or inclination to build their own portfolios from scratch. Just remember that if you fall out of love with your funds, you do have options.

Beutel Goodman Investment Counsel:

Minimum Initial Investment: $10,000

Fund Highlight: Beutel Goodman Income - above average returns for eight straight years

Contact: http://www.beutel-can.com or (800) 461-4551/(416) 485-1010

Chou Associates Management :

Minimum Initial Investment: $10,000

Fund Highlight: Chou RRSP - its 10-year return is more than double the average Canadian equity fund

Contact: http://www.choufunds.com (under construction)_(416) 367-4941

Leith Wheeler Investment Counsel:

Minimum Initial Investment: $50,000

Fund Highlight: Leith Wheeler Balanced - consistently better-than-average returns

Contact: http://www.leithwheeler.com or (888) 292-1122/(604) 683-3391

Mawer Investment Management: Minimum Initial Investment: $5,000

Fund Highlight: Mawer Canadian Balanced RSP - reliably better-than-average returns

Contact: http://www.mawer.com or _(888) 549-6248 or (403) 262-4673

McLean Budden:

Minimum Investment: $10,000

Fund Highlight: McLean Budden American Equity - one of the best long-term performers in the U.S. equity category

Contact: http://www.mcleanbudden.com or (800) 884-0436/(416) 862-9800

Phillips, Hager & North Investment Management:

Minimum Investment: $25,000

Fund Highlight: PH&N Dividend Income - one of the best funds in the country, period

Contact: http://www.phn.com or _(800) 661-6141/(604) 408-6100

Saxon Funds Minimum Investment: $5,000

Fund Highlight: Saxon World Growth - strikingly superior returns over the past five years

Contact: http://www.saxonfunds.com or (888) 287-2966/(416) 979-1818

Series schedule

Monday

Rapid trading in mutual funds bears marks of market timing

Mechanics of market timing, who does it, who doesn't and why

Tuesday

Proposed rules for fund governance favour industry, critics say

Wednesday

Not all fund managers have suffered the same pain as investors

Thursday

Fees and fund performance don't always go hand-in-hand

Yesterday

Segregated fund fees on the rise

Today

Dos and don'ts for the investors

On the Web

Follow the mutual fund series this week on our website http://www.globeandmail.com

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