“What the mind doesn't understand, it worships or fears.” – Alice Walker
A few weeks ago, I ran an education session for some people who were all members of the same Group RRSP plan. During the session I handed out a variety of fund profiles and asked the members to pair up and discuss the similarities and differences between the profiles they’d been given and then we discussed their observations as a group. My hope was that, in having a simple discussion with a partner and then an open discussion with the group, it might take some of the fear out of the investment selection process that comes when you’re confronted with a sea of pie charts, graphs and tables and have no idea what it all means. We used funds from their group RRSP fund lineup and focused on looking at 5 things to help with choosing a mutual fund: (you can see a sample fund profile here and find more at www.morningstar.ca)
1. Category (Asset Class)
We had talked earlier in the session about how investors tend to fall into either an “active” or a “passive” category. Active investors like to build and manage their own portfolio using a selection of funds whereas passive investors tend to prefer a “set it and forget it” strategy. An active investor might create a diversified portfolio by selecting 5-8 funds from different categories (Cash, Fixed Income, Canadian Equity, US Equity, Global Equity for example), decide what percentage to invest in each category based on an appropriate asset allocation model and then rebalance those funds once a year.
Related article: Making sense of Rebalancing a portfolio
The passive investor on the other hand might choose one fund from either an Asset Allocation or a Target Date category based on either their risk tolerance (AA) or estimated retirement date (TD). The AA and TD funds are diversified and managed by a fund manager according to the goals of the fund which makes them a great option for investors who don’t have the time, inclination or confidence to build and manage their own portfolio of funds.
Related article: Target date funds make investing easy
When you know whether you’re an active or a passive investor, taking a look at the fund’s category tells you whether it’s suitable for your goals and investor type.
Simply put, a fund’s volatility is an indicator of how risky it’s considered to be; the higher the volatility, the greater the risk. As an investor it’s extremely important to determine your own comfort level when it comes to risk. In theory, the greater the risk, the greater the potential for reward and the further away you are from needing your money, the more risk you can afford to take. However, if you know that seeing a significant drop in the value of your portfolio would worry you and stop you from sleeping, it doesn’t matter how long your timeframe is, you don’t want to be invested in anything that’s considered more volatile than you can stomach. Looking at the fund’s volatility ranking helps you determine whether or not it’s an appropriate choice for your investment goals.
3. Returns – Annualized & Calendar
Most fund profiles will show annualized returns over 1, 3, 5 and 10 years which gives you an idea of how the fund has performed through good and bad markets. Past performance should never be considered an indicator of future performance but it can be used to gauge volatility and it gives you something to compare performance to moving forward. Many profiles will also show calendar year returns and I like these because they show very clearly the highs and the lows of the fund. I use the calendar returns as my “gut check”.
Related article: How do you judge performance?
If I can look at the worst years and know in my gut that seeing those returns on my statement wouldn’t make me want to sell and switch to something “safer” then I know I’m ok with that fund. If the worst returns make me nervous, I know I don’t want to touch that fund with a 10 foot pole, no matter how tempting the returns from the good years might be!
4. Top Holdings & Asset Allocation
A mutual fund is basically a large pool of money that is managed by the fund manager. When you invest in a mutual fund you add your money to the pool and you get to share in the profit (or the loss) that is made by the fund. The fund manager uses the money in the plan to invest in individual companies or other mutual funds. These investments are called the fund’s “holdings”. The top 10 list tells you which companies the fund manager has invested the largest percentage of the plan’s money in. These holdings will change according to the directions of the fund manager.
When we talk about Asset Allocation, we’re describing the way that the pool of money (assets) has been invested (allocated) and to do this we often look at two specific categories: “equities” and “fixed income”. The equity portion is the percentage of the fund assets that are invested directly in the stock market (usually in shares of individual companies or other mutual funds). The “fixed income” portion is the percentage of the fund assets used to buy investments like bonds which pay a guaranteed amount of interest over time or other mutual funds that invest in fixed income products. Fixed income investments are less volatile than equities. This is because the value of equities changes with the performance of the stock market so they have the potential to generate high returns but they can also decrease significantly in value when the market is low.
Related article: Understanding Asset Allocation
Generally speaking, the higher the percentage of equities in a fund, the greater its volatility level and the greater the risk.
In Canada the investment fees are embedded. (That’s an industry term for, “we tuck them away so you can’t easily see them”). Often investors think that they’re not paying any fees because they don’t see them on their statements but that’s because by law your statements have to report your actual net return (after fees have been deducted) so that you know what the value of your investments actually is. Fund management fees (MERs) are deducted from the fund’s gross return and can dramatically impact your investment return which is why it makes sense to keep your fees as low as possible. For example, if you invest in a fund which has a gross return of 8% and an MER of 3% you’ll see a net return on your statement of 5%. A different fund which also has a gross return of 8% but has an MER of 2.5% will give you a net return of 5.5%. That 0.5% might not seem like a big deal but, over time, it could make thousands of dollars of difference to your portfolio in the same way that cutting your mortgage rate by 0.5% can save you thousands of dollars in interest over the life of the mortgage.
Related article: Mutual fund fees do matter
At the end of the day, it’s worth remembering that when it comes to choosing a mutual fund, a simple strategic approach that is consistently implemented gives you the best chance of maximizing your returns. Understanding your investor type and your risk tolerance as well as knowing how to select key information from a fund profile will help you ensure that the funds in your portfolio are in line with your goals and performing appropriately.