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If slacker funds aren't doing their job, fire them

Your funds' management expenses should be justified by returns, ROB CARRICK advises

SOURCE: WWW.GLOBEFUND.COM

It's time to strike a blow against slacker mutual funds.

You'll know them by their higher-than-average management fees and their sub-par returns. Dead weight like this is exactly what you don't need in the current investing environment.

Contrary to what you might think, this is not another rant about the benefits to investors of low fund management expenses.

Rather, it's a call to evaluate whether the expenses you're paying are justified by your returns.

Here's what to do. Start by looking up the funds you own in the listings contained in Net Worth Monthly to see how their MERs and returns compare to their category average.

Let's arbitrarily say that warning bells should go off when an MER is 0.2 to 0.25 of a percentage point above the average. Don't discount this differential as trivial.

If you invested $10,000 for 15 years in a fund that made 10 per cent before expenses, you'd end up with an extra $1,080 if your MER was 2.5 per cent versus 2.75 per cent.

As for judging your returns, you'll want to see how they compare with the average over both short- and long-term periods. Are any of your funds well below average on a consistent basis?

And are the MERs well above average? If so, you've got a strong case for considering some alternatives.

Let's take a look at some slacker funds. All have an MER at least 0.25 of a percentage point above the average, and below-average returns. As well, each has at least $100-million in assets. Very small funds sometimes have high MERs because they lack the economies of scale of their larger competitors.

If there's a poster fund for the slackers, it's the Investors Retirement Growth Portfolio, a Canadian equity fund with an MER of 3.13 per cent.

You can't properly grasp how egregious this MER is until you understand that the average for Canadian equity funds is more than half a point lower, at 2.61 per cent.

If you charge more than average, it's only fair that you beat the average return as well. Investors Retirement Growth Portfolio doesn't.

While it has fared somewhat better than average in the past 12 months, its longer-term compound average annual returns seriously lag the average Canadian equity fund.

Check out the 10-year numbers to June 30: 8 per cent for Investors Retirement Growth Portfolio, 9.3 per cent for the average fund and 9.9 per cent for the benchmark S&P/TSX composite index.

Clearly, the obesity of this fund's MER has penalized long-term unitholders. It's not the whole reason why the fund has underperformed, but it is a significant reason.

Another slacker fund in the Canadian equity category is the Acuity Clean Environment Equity Fund, a socially responsible fund with a sustainable development theme. This fund's difficulties go far beyond its bloated 3.21-per-cent MER. In the year to June 30, it lost 18 per cent while the average fund lost 4.2 per cent and the index fell 6.1 per cent.

With returns like these, you have to ask what justification there is for charging an MER that is an amazing six-tenths of a point above the average. If it's the socially responsible aspect that appeals, there are other choices out there.

Interestingly, Clean Environment Equity could easily have justified its high MER back in the mid-1990s, when it reeled off gains of between 20 and 40 per cent in four out of five years.

The lesson here for investors is that superlative returns are not a sustainable justification for a high MER. At some point, returns will falter, but the MER is forever.

Some slacker funds charge a lot but never seem to deliver the goods. Take AIM European Growth, for instance.

With its 3.09-per-cent MER, this fund is well above the category average of 2.72 per cent. Performance-wise, it's well below the average.

The fund's compound average annual return over the past five years was 0.6 per cent, while the category average return was 2.3 per cent. In the year to June 30, the AIM fund's loss of 23.4 per cent was more than double the average fund's decline.

Another slacker fund is the AGF Canadian Money Market Account, with an MER that is 0.48 points above the category average at 1.55 per cent.

Have you taken a look recently at what money-market funds are paying out? With interest rates as low as they are, you won't get much. AGF Canadian Money Market returned 1.4 per cent in the past year, the average fund 2.1 per cent. Blame the MER.

Note that there is a wide variety of cheaper money-market funds out there, many of them from bank fund families.

Bank funds tend to have MERs around the average, but there are some slackers to be found. Take Scotia CanAm Stock Index and its MER of 1.43 per cent.

Here's a fund that tracks the S&P 500 index and yet is fully eligible for registered retirement accounts (it uses derivatives to replicate the index's returns).

This sounds like a good proposition, except for one thing: Other bank fund families offer the same fund option at a much cheaper cost.

For example, there's TD U.S. RSP Index at 0.87 per cent. If you're up for buying a fund on-line, the e-fund version of the TD fund offers an MER of just 0.48 per cent.

Low MERs are especially important in index investing because your returns are basically what the index makes, minus management expenses and a minimal amount to account for index-tracking glitches.

Here's how this works in the real world. Scotia CanAm lost 19.4 per cent in the year to June 30, while the comparable TD fund lost 18.9 per cent.

It's possible in your search for slacker funds that you'll come across a rare animal -- the high-MER, high-achieving mutual fund.

A good example is AGF European Equity Class, with a corpulent MER of 3.29 per cent and a five-year track record of running roughshod over most other funds in this category.

Its five-year return to June 30 was 11.9 per cent, compared to 2.3 per cent on average.

Another example is Northwest Growth, which has an MER of 2.89 per cent but vastly better returns than the average fund over most time frames throughout the past decade.

High MERs are just fine in a mutual fund, providing they're justified by excellent returns. If a high-MER fund can't manage this, then it's a slacker.

Now, what do you do about a slacker in your portfolio?

If you have a financial adviser, ask for a rationale for why you own a high-MER, low-return fund. It may be that the original reason for buying no longer applies, or that the alternatives are better now than they were before.

If you invest for yourself, see if you can replace your slackers with funds that offer a better balance between what they charge and what they deliver. In today's tough markets, this is basic stuff.
Slacker funds
Funds with above-average management expense ratios and below-average returns

                                                   Category


                                     Assets          average   5-year.5-year


Fund                                 ($million)  MER    MER    return.averageAcuity Clean Environment Equity        $144.7    3.21%  2.61%  -2.4%  +3.6%


AGF Canadian Money Market Account       614.9    1.55   1.07   +2.9   +3.6


AIM European Growth                     141.8    3.09   2.72   +0.6   +2.3


Investors Retirement Growth Portfolio.1,374.0    3.13   2.61   +2.5   +3.6


Scotia CanAm Stock Index                403.2    1.43   1.05   +0.9   +1.7

And a pair of funds with high MERs and stellar returns

AGF European Equity Class                $501.9    3.29%  2.72%.+11.9%.+2.3%


Northwest Growth                          199.3    2.89   2.61   +8.5  +3.6

-*Returns to June 30

© 2007 The Globe and Mail. All rights reserved.

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