Selecting a Mutual Fund
Using a Screener
Mutual funds play a dominant role in Canadians’ investing lives. Even for the self-directed investor, that is, someone who does not have an investment advisor recommending particular investments and who could therefore choose to invest in individual stocks, mutual funds continue to be attractive because of their relative simplicity to purchase. They also allow you to automatically invest new deposits in the account without having to worry about making a single transaction. Because of their widespread appeal and the fact that there are quite literally thousands of funds to choose from, this post will be about helping you to narrow down your choices.
Assumptions
You are in your mid-40s and have been working full-time for more than 20 years. Throughout that time, you have been investing in your Registered Retirement Savings Plan (RRSP) via your local bank branch. As you have a defined contribution registered pension plan through your employer, the pension adjustment has reduced the amount permitted to be contributed to your RRSP to about $5,000 per year. Over time, you have amassed $185,000 in your RRSP, so you think you are doing pretty good. However, you recently read an article that talked about the high fees that some mutual funds charge. When you ask the financial advisor at your bank, you learn that the Management Expense Ratio is 2.5 percent of your assets. You pull out your calculator and discover that, at $185,000, that works out to about $4,600 per year, and you wonder how much that has added up to over the years (Answer: over $38,000). You decide that you can save some money and do better on your own, so you transfer your mutual fund over to the discount brokerage affiliated with your bank and sell it out.
Now you have $185,000 in cash sitting in your account. What do you invest it in? You know that you want to keep on making bi-weekly automatic contributions on your payday, so you decide that you need to stick to a mutual fund. How do you choose the right fund?
Determining your Screening Criteria
Fund Category
For the purposes of this blog post, I used the screener available through the brokerage where I hold some of my accounts. The largest single mutual fund available is a bank-owned fund in the Global Neutral Balanced category. This is a good place to start actually, if you want your investment to be held in a single fund, as it includes both fixed income or bond investments, and equity or stock investments. As it is a global fund, there are investments from Canada, the US and the rest of the developed world. The term neutral in the category means that the fund must invest between 40 percent and 60 percent of the fund’s assets in equities. This screen resulted in 389 possible funds to choose from.
Purchase Info
As our hypothetical investor has $185,000 to work with, a large minimum is not really an issue but for people with relatively smaller amounts to invest, this could be a challenge. To broaden the applicability, I have set a minimum initial investment of less than $5,000. Many mutual funds also have minimums for subsequent investments, although these minimums are often further reduced for pre-authorized contributions. Given that our investor wants to make bi-weekly contributions that add up to about $5,000, he is looking at a contribution amount of a little less than $200. I also made sure that the funds in question were eligible for RRSPs. The result: our universe of available funds was reduced to 250.
Management Expense Ratio (MER)
Research by Morningstar has shown that there is a significant inverse relationship between the fees charged to manage a mutual fund and the performance of that fund. In other words, the probability is that a mutual fund with a lower MER will likely do better than a mutual fund with a higher MER. Put differently, “you get what you don’t pay for.”
So far, I have selected the category of Global Neutral Balanced and for minimum initial investments of less than $5,000. The MER for the priciest mutual fund is an amazingly expensive 3.00%, while the lowest MER rings in at only 0.77%. On the basis of Morningstar’s research, I am going to limit the MER to anything below the average. The highest MER has now been brought down to 1.65%. This also reduced the eligible funds down 29.
Risk
Standard Deviation
There are several ways of measuring the risk inherent in a mutual fund investment. Risk in the investment world is less about the risk of loss than it is about deviation from the expected return. Despite an expected return of, for example, 7% per year, you may never actually have a year in which the fund had an investment return of 7%. It could easily fluctuate from a 3% loss one year to a 17% gain the next. That is risk. Here is a chart that illustrates the risk known as standard deviation:
Most of the time, returns will fall somewhere in the middle of the bell curve, but at either end of the curve there can be an increasingly unlikely outcome of really awful (left “tail”) or really wonderful (right “tail”) returns. While we would all love to have a very fat, long right tail, and a very short skinny left tail, we usually have to take the bad with the good.
Returning to our global neutral balanced fund search under risk, standard deviation is one of the available statistical analyses available. In order to sleep better at night, I will select for lower than average standard deviations. Available funds are now reduced to 20.
Sharpe Ratio
Another measure of risk is the Sharpe Ratio, named after William F. Sharpe, winner of the Nobel Memorial Prize in Economic Sciences. The ratio he used was the average return of a particular investment less the risk-free rate which is then divided by the standard deviation of the returns. You don’t really need to know the formula. Just be aware of what it is and that generally speaking the higher the number, the better. I have selected for any results that are above average. Now there are only 14 funds available.
Performance
Mutual fund analysts often measure the performance of the funds relative to other funds in the same category by quartile. To explain, imagine there are 100 mutual funds in a given category. They are ranked according to performance over a given period, typically one, three, five and ten years. The top 25 funds are in the first quartile, funds that are ranked from 26 to 50 are in the second quartile, those ranked 51 to 75 are in the third quartile and the worst performing funds in that period, those ranked 76 to 100, are in the fourth quartile. Some mutual fund managers invest in a fairly narrow choice of funds, so they could easily perform really well one year and quite poorly in the next, resulting in first quartile performance one year, and fourth quartile performance the next. As you can imagine, they would also have quite a large standard deviation of returns.
To be conservative, I will select all the time frames, 1, 3, 5 and 10 years, and only first and second quartile performers for each time. Interestingly, once I got to the five and ten-year time frames, the number of funds was reduced to three, as some had not been around that long to be measured.
The Results
The results, somewhat to my surprise, were two funds from TD Asset Management and one fund from RBC Global Asset Management. I will not provide the fund symbols as I don’t want this little post to come across as a recommendation. I will note, however, that they are D-series funds that have a much lower MER than you would be able to find at a bank branch. I would also suggest that these are not necessarily the most important combinations of criteria for selecting a mutual fund. To some extent, I have sacrificed performance for conservatism and a lower barrier to entry in terms of the minimum initial investment.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.
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