Periodically we get phone calls inquiring about our services. One of the first things we talk about is the importance of matching both the approach to investing and the style of investing. If you had a room full of financial professionals, even within the same firm, the approach and style of investing would not be unified.
Ensuring both you and your financial professional share the same approach and style of investing is the first conversation. The approach to investing typically begins with what type of investment products you believe in. As an example, you could ask a wealth adviser if their approach is to recommend mutual funds or individual securities (i.e. common shares)?
Why do they feel that this approach is best?
Education and licencing provide options for clients
Some financial professionals are licenced only to sell mutual funds and naturally they love mutual funds and can clearly articulate why they feel this is the best approach for you. One of the reasons I was attracted to the financial services industry was the ability to analyze good companies and use my education to pick individual stocks.
In order to provide all possible investment options to clients, I quickly understood that you had to get licenced with the Investment Industry Regulatory Organization of Canada (IIROC). If a person is licenced only with the Mutual Fund Dealers Association (MFDA), then they are limited to talking about mutual funds.
Financial firms are different
Perhaps one of the more confusing components for clients is knowing where to go for financial assistance. For example, if someone with $100,000 calls a full-service brokerage firm, they will likely be told they are calling the wrong place. They will likely be directed to the bank division or self-directed options. The types of accounts with full- service brokerage are normally meant for clients with $250,000 or higher.
On the flip side of that could be a person who has $1,000,000 and goes into a bank. Each bank has a full-service investment division that normally deals with the larger accounts. If a person doesn’t know to ask for the full-service brokerage division they may be presented with two investment product choices the bank can offer — mutual funds and/or guaranteed investment certificates.
Proprietary products
Some financial firms will primarily offer their own mutual funds. The big question to ask is if those proprietary funds can be transferred to other financial institutions if you are not satisfied with the service and performance of the investments. If the answer is no, I would encourage investors not to purchase them. Flexibility is the key to having peace of mind.
Some proprietary products are issued by insurance companies called segregated funds. Prior to purchasing any segregated funds, I would encourage you to read all the fine print. In many situations I have sat down with individuals who have purchased segregated funds because their financial professional had a life-insurance licence and highlighted only the good components of this insurance product. I recommend understanding all the pros and cons with respect to any structured product.
If you do not understand all the financial jargon, I would recommend you speak with someone you trust to understand what you are getting into.
Second opinion provides clarity
When individuals are looking to invest some funds or get a second opinion, I encourage the sharing of information. For example, if you were to see three people before making the decision of who to work with, I would ask permission to be able to share the information and proposals with others. If you shared the proposals among each of the three individuals you are working with then you are more likely to hear about the pros and cons of each approach. If you have a segregated-fund strategy or a basket of mutual funds as a strategy then this can easily be analyzed and compared with the approach of purchasing direct holdings.
Classes of funds
When we have done reviews of portfolios we have noted situations where certain types of classes of funds cannot be transferred. When I look on Morningstar, a mutual fund screening system for wealth advisers, it displayed 24,020 different 91原创 mutual funds. I see many different series of funds, including Series A, B, C, D, F, G, H, I, O, P, T, V, W, Q, etc.. Even within those series letters they may have subsets, such as T1, T2, T3, T4, T5, T6, T7, and T8.
As an example, we met with a person who came to see us because he was not happy with both the performance and the service he was receiving. He was invested in the “O Series” of mutual funds for many years. Although this individual had created capital gains, based on the length of being invested, they had significantly underperformed the market.
Unfortunately, this individual was unaware that their current adviser had put them into a series of funds that could not be transferred to another firm. This essentially meant that the only way this individual could make a change to his situation is if he liquidated the holdings and triggered all of the taxable capital gains in one year. If the current wealth adviser had originally recommended to the investor to purchase a different transferrable class of funds, or individual holdings on an exchange, they could be transferred in-kind and no tax would be triggered.
Concentration
Over the years we have provided many proposals to individuals who are deciding on how to invest their money. An area of discussion deals with concentration. The saying, “don’t put all your eggs in one basket” is good advice. We would never recommend putting all your money in one or a few individual companies.
On the flip side, we feel just as strongly about not holding too many names. We have provided second opinions on portfolios where an investor will have dozens of different mutual funds, with some of the funds holding hundreds of different names. When you analyze all of the holdings together, there is often over a thousand names with a very minor holding in each company.
We feel strongly about optimizing the number of holdings in your portfolio. The number of holdings will typically range from 25 companies to 35 companies depending on the size of the investment portfolio and the asset mix. We feel that concentrating your holdings in the best names is a better strategy then spreading it out among thousands of companies.
Dividend Reinvestment Plan
Distributions from a mutual fund can be typically paid as cash or can be reinvested in more units of the mutual fund. This is normally an all-or-none type decisions. When you have individual holdings you can pick and choose which companies you would like to set up the Dividend Reinvestment Plan (DRIP). Some companies offer a discount on the DRIP and others may be appealing to set up the DRIP at certain price levels. All of this can be controlled with individual holdings.
Being engaged in the investment process
Over the years we have transitioned hundreds of clients from mutual-fund portfolios to individual holdings.
One comment we always hear from new clients is that they are excited to follow their holdings and understand what they are invested in. I’ve had so many people tell me that they were not really engaged in the investment process when they held mutual funds. It was always tough for them to see what they actually owned when it is wrapped up in a mutual fund or segregated fund, especially if they held many different structured products.
When they have individual holdings they can easily put the names in their phones to follow the prices, and read news about the companies.
Maintaining the status quo
Mutual funds are one of the first investments that people are introduced to. Sometimes it starts with a small initial deposit. In other cases, a monthly pre-authorized contribution (commonly referred to as a PAC) could have been set up.
Over the years, with continual saving the account has grown to the point where diversification can be achieved through purchasing direct holdings. What we have found is that it is easier for some people to maintain the status quo of continuing with mutual funds even though their net worth has grown and they could achieve diversification by transitioning to direct holdings.
Ongoing management
One reason why investors may be attracted to mutual funds is the ability to have a mutual fund managed by a portfolio manager that will make discretionary investment decisions. It is essentially a hands-off approach. Your focus is on saving money, and purchasing more mutual funds.
Portfolio managers also have the ability to purchase individual investments on behalf of clients, outside of a mutual fund structure. The primary difference is that your capital is not pooled with other investors and can be customised to your unique situation.
Negotiating fees
The ability to scale with lower fees typically comes when you are either dealing at the institutional level with really large accounts, or with negotiating the fees with a portfolio manager holding individual holdings. When we open up fee-based managed accounts with clients we negotiate the fee schedule — it is customized.
Essentially, the greater the dollar amount you are investing, the lower the fees will be. We often see larger portfolios holding many different mutual funds and structure products. In these situations the investor is often not getting the advantage of lower fees as they invest more. Once our clients hit certain milestone, such as $1 million, $2 million and $5 million their fees are adjusted even lower.
Fee Transparency
Over the last couple of years the mutual fund industry has made considerable strides in the right direction with respect to transparency.
If you are currently investing in mutual funds it is important to understand the fee disclosure reports. If you are reading a report that says the fees paid to your adviser, this is only part of your fees. You must also add the fees that are embedded by the fund and kept by the fund company. Once you have added both of these together you will get a better approximation of your total cost of investing.
On the offering documents the fund companies are required to disclose the Management Expense Ratio (MER). There are costs, such as trading, that are not included in the MER that should be factored in as well.
Every year we provide our clients with a fee summary report for full transparency. Our clients do not have to wonder if they have to add other items onto this list. When our clients hold all individual holdings then no fees are embedded.
Managing mutual funds adds extra layers of fees
When you own a mutual fund, your adviser, the financial firm, the fund company, and the manager of the fund all get paid. We would prefer to eliminate a couple of those people and pass those savings directly onto our clients. We do this by purchasing direct holdings in a fee-based account. In most cases we are able to cut new client fees by more than half if they were previously invested in mutual funds.
Tax benefits of holding individual holdings in a fee-based account
Another benefit of avoiding mutual funds, and opening a fee-based account with direct holdings, is the ability to deduct investment council fees.
If you have a non-registered or corporate investment account holding mutual funds then you are not able to deduct the MER within mutual funds. If instead you had a fee-based account holding individual securities, there would be no embedded costs and you would be able to deduct the fee as an investment council fee.
Understanding mutual-fund trusts and corporations
Mutual funds are either set up as a trust or as a corporation. If you have a mutual-fund trust then the trust has to flow all income out to the unit holders as it would be taxed at the highest personal tax rate if the income was retained. If the fund was forced to sell investments during the year to fund other individuals’ redemptions then these transactions would impact all investors in the fund.
Mutual-fund corporations also flow through 91原创 dividends and capital gains to all unit holders. The key component to understand here is the word 91原创 dividends. If you have foreign income within the mutual-fund corporation, it must first pay tax inside the corporation. Most of our equity investments are outside of Canada and having two layers of tax on this income, when held in a mutual-fund corporation, is a negative.
It is important to also note that income-tax slips can still be issued for mutual funds when investment returns are negative. Extra caution should always be taken on purchasing funds near the end of the year when some companies make taxable year-end distributions. If you are in the lowest tax bracket then getting unexpected tax slips at the end of the year may be okay. If you are in a higher tax bracket you would have better control of your year-end t-slips if you held individual holdings.
When you hold individual holdings you also have better control over the realized gain (loss) amounts annually.
We can look at your carry-forward numbers for the last three years and use strategy on whether to realize capital gains or losses in a particular year. It can be especially frustrating to prematurely pay tax because of the mutual funds rules or because other individuals require funds that resulted in the fund triggering unnecessary taxable distributions.
Kevin Greenard CPA CA FMA CFP CIM is a portfolio manager and director of wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138.
