Segregated funds are incredibly popular because they have tremendous marketing appeal. Think about it! You buy an investment that has all the upside of mutual funds and no downside because your capital is guaranteed. On that basis, who wouldn't buy these funds?
Skeptics, however, start to question – what's the catch here?
Upon closer examination, you discover that getting your money back is not as easy as expected. In fact your money is returned under two circumstances:
- If you die, and,
- If you invested for a ten year period.
The marketer then discusses how you can reset the guarantee when your fund grows so that you can (a) lock in and protect not only your original investment, but (b) the growth. There are also benefits of protection from creditors and probate. And, depending on your personal situation, there may even be a few tax benefits.
The objective approach
If we look at segregated funds objectively, the reality is that there are some very important benefits. They are:
- Guarantee of capital at death
- Guarantee of capital after ten years
- Resetting privileges to lock in growth
- Protection of assets from creditors
- Probate protection
All these benefits, however, come at a cost. The Management Expense Ratios (MERs) of segregated funds tend to be higher than mutual funds. The question to ask yourself is therefore “Is the cost worth the benefit?”
I like to think of segregated funds as mutual funds with options. To use an analogy with the auto industry, you can go to a dealership and look at the base model of a car. You can then start adding options and packages like power windows, air conditioning, CD player, leather seats, bigger engine, sunroof, etc. These options all cost extra. If you think the cost is worth the benefit, you will purchase the options.
With segregated funds, you have to decide whether the benefits of the five options listed give you enough extra value.
An academic approach
Dr. Moshe Milevsky, professor at York University, wrote one of the best and most objective evaluations of segregated funds that I have ever read. His full article can be found on the Internet here.
From his research, Dr. Milevsky calculates the amount that you should pay for some of these benefits. The harsh reality is that many segregated funds are charging excessively through higher management expense ratios.
Everyone is different
In the end, the decision is still yours, because in the final analysis, you have to determine the value of segregated funds for your investment portfolio. I might think that a sunroof at $250 is the best deal around because I love sun and fresh air. On the other hand, my father might think it the biggest waste of money in the world.
Go through each of the five main benefits of segregated funds and determine whether they appeal to you. Then if you can, determine how much you are willing to pay for each benefit. To return to the auto industry analogy, I buy cars that are two years old and my only requirements are that they have good resale value and good fuel economy. Most options I can take or leave, but I have a soft spot for heated seats, air conditioning, cruise control, a sunroof and a CD player.
From an investment standpoint, I am frugal (some call me cheap). I am also very analytical. I will likely leave segregated funds to the more emotional investor.