By Jonathan Chevreau
National Post
FP Investing, Personal Finance
Wednesday, May 7, 2003

Mutual funds still popular -- if you're a planner or advisor.

Mutual funds are still the financial planner's investment vehicle of choice, despite increased competition from alternatives.

A whopping 92% of planners still use mutual funds and allocate an average of 46% of client assets to the product, according to a survey of 653 advisors conducted by Financial Research Corporation (FRC) of Boston.

"Mutual funds are certainly not shrivelling up and dying," says FRC consultant Christopher Brown.

But do mutual funds deserve such continued market dominance? Stephen Gadsden, says mutual funds make up so much of U.S. portfolios because advisors are paid to retain fund assets by fund manufacturers -- in much the same way as advisors here in Canada.

In both countries, funds are sold on the assertion that portfolio diversification gives investors the best protection from volatile markets. But that assertion has worn thin, given the failure of most equity funds to protect investors from the bear market.

Canadians have staged a de-facto buyer's strike related directly to unhappiness over the failure of costly funds to protect them from losses the last three years.

Mediocre performance is followed inevitably by poor sales. On Friday, the Investment Funds Institute of Canada said net redemptions may pass $1.6-billion in April, the highest outflows in more than a decade.

True wealth preservation comes not from long-only equity fund managers but from asset allocation, which is why the scared money retreated early to bonds, GICs and income trusts.

Even the braver money still in equities is getting more cost sensitive, which is why passively managed exchange traded funds (ETFs) are grabbing market share. IFIC's research shows $1-billion flowed into ETFs last year.

The FRC study is "consistent with what we're seeing," says Stephen Rive, general manager for Barclays Investors Global Canada. However, he adds, "for most financial planners, using ETFs is a problem because they are not securities licensed."

Old-fashioned stockbrokers who are licensed to sell ETFs as well as stocks and bonds are making a comeback.

"Dividend-paying, blue-chip bank stocks and the like have returned to favour," says Stephen Kangas. "Clients are telling advisors they want to know what they own, they want less fees and they don't want distributions."

Hedge funds are attracting affluent investors tired of settling for the relative performance of mutual funds that are only "long" the stock market. ("Great news, Mr. Client. We lost 50% of your money but we beat the index, which was down 51%.")

Hedge funds shoot for absolute positive returns. Instead of being paid for trying (and too often failing), hedge funds only pay big fees to managers when they also make money for clients.

Fund executive Dan Richards says the pendulum has "swung from insufficient skepticism in the heyday of the 1990s to today's excess skepticism. Clients have gone from believing everything to believing nothing." This crisis of confidence shows up as a reluctance to add new money to mutual fund positions.

Richards says investors don't feel confident the risks they take will be rewarded by the market. They're saying: "I don't know who to believe, so I won't believe anybody." It will take a few years before investors come back in large numbers, and then only when the markets bounce back.

Fee-only advisor Adrian Mastracci of KCM Wealth Management has noticed increased client interest in minimizing management expense ratios (MERs) since 2003 began. That's one reason "ETFs and index funds are making more inroads into the traditional arena." He's seeing more portfolios constructed with ETFs and bond ladders.

Investors have also awoken to the enormous duplication of securities in most funds, he says. Someone with four Canadian equity funds will own various combinations of the big banks in all the funds, as well as stocks such as BCE Inc. and Alcan Inc.

FRC notes increased movement to separately managed accounts, which depart from the "pooled" concept of funds and allow clients to hold custom-picked individual securities in their own names, with fees well below what retail mutual funds charge.

Even so, FRC's study is a bracing reminder that, to paraphrase Mark Twain, the death of the mutual fund industry has been greatly exaggerated.

"I don't think anybody's saying mutual funds are dead," says fund analyst Dan Hallett, "Rather, the industry's biggest growth years are behind it. When you become the dominant investment product of choice, how much growth is really left?"

IFIC's rising redemptions appear more modest if measured against percentage of assets. Considering we're near the end of the worst bear market since the 1970s, if not the 1930s redemptions could have been much worse by now.

"Once things stabilize we'll see a return to net sales," Hallett says, "Investment funds will continue to be an important part of Canadians' portfolios."

Gadsden disagrees. He believes Canadians have awoken to the mutual fund myth and should embargo future purchases of "high-priced, underperforming mutual funds and go for EFTs and stocks."

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Good news for those who missed yesterday's deadline to purchase Ontario Opportunity Bonds. The deadline has been extended until May 13.

NOTE: The information provided above is intended for general informational purposes only. It does not constitute advice for anyone's specific situation. Everyone should always first consult directly with their advisors to determine the appropriateness of any information contained above before taking any action. KCM Wealth Management Inc. assumes no responsibility for any loss or damage arising from the use of, or reliance upon the above information.