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Is seg fund security worth the high cost?

You'll pay steeper MERs for extra safety

If fear and greed drive financial markets, then fear has definitely taken the wheel these days. Take last week's market reaction to news that North Korea is testing missiles off its coast. If it's not a crazy dictator, it's the threat of avian flu, terrorism or natural disaster. You can't blame investors for looking to secure their retirement nest eggs, but there is such a thing as security overkill -- and that could be the case if you own segregated funds.

Segregated funds are mutual funds wrapped in a life insurance product. They were first introduced in the 1980s primarily for self-employed investors wanting to protect their savings from creditors in the event of bankruptcy -- much like any life insurance product.

Segregated funds differ from mutual funds because 75 to 100 per cent of the principal is guaranteed, provided the investor holds the fund for at least 10 years or until death. That guarantee has its price in the form of higher fees. Management expense ratios (MERs) can be as high as 9.8 per cent for a 100-per-cent guarantee and nearly every seg fund has a front- or back-end load.

Through the years, seg funds have become increasingly popular with mainstream investors looking for extra security.

"They have the growth potential of mutual funds with the security of an insurance policy," said Eric Valderrama, vice-president of national and institutional sales at AIC Ltd. "It really ends up coming down to the individual investor and their needs. Some are quite risk averse."

AIC Ltd. offers a line of more than 20 segregated funds from global equity to money market. It's just a drop in the bucket compared with the more than 2,000 seg funds available on the Canadian market. In most cases a segregated fund will mimic a regular mutual fund. You name the asset class and it's likely there are several mutual fund companies with a corresponding segregated fund. When it comes to MERs, the difference between segregated funds and their twin non-segregated fund is often huge.

That's where security overkill could come in. Even the most volatile asset classes rarely lose money over a 10-year period. As an example, TD Asset Management Inc. charges investors a 3.2-per-cent premium for the segregated version of the TD Science & Technology Fund. Over the past 10 years the average science and technology fund has lost less than 1 per cent annually, while the Nasdaq 100 composite index has gained 3.5 per cent.

AIC Ltd. dings investors for an extra 3.3 per cent for the segregated version of its AIC Advantage II Canadian equity fund. Over the past 10 years the average Canadian equity fund gained 9 per cent annually while the S&P/TSX total return index rose more than 10 per cent.

The fee premium tends to drop for segregated funds as the level of risk declines. CI Investments Inc. charges 4.93 per cent for the segregated version of its CI Global Boomernomics fund and 2.39 per cent for the regular version. The average global and balanced asset allocation fund has risen 4.4 per cent annually in the past 10 years.

But the worst case of security overkill has to be segregated Canadian money market funds. AIC's segregated and non-segregated versions both hold short-term government treasury bills and low-risk corporate debt, but the segregated version costs investors 0.87 per cent more in management fees annually. While the average Canadian money market fund has returned a mere 2.85 per cent annually, Canadian money market funds have never been known to lose money.

Morningstar Canada analyst Mark Chow said the only asset class with a negative 10-year return in recent history is Japanese equities -- and that occurred back in the late 1980s. "Most markets won't see a negative return over that time span. So if you're playing the odds, the extra insurance is not necessary."

Of course, past returns are no indication of future performance and Mr. Chow said he understands how some investors looking for security from volatile markets would benefit from segregated funds -- even if it's just for peace of mind. "Segregated funds should be considered an insurance product and not an investment," he said.

Mr. Chow also says segregated funds continue to be a good product for self-employed individuals looking for a creditor-proof investment.

Eric Valderrama said AIC is currently reviewing its "environment for fees" and the company has put what is called a soft cap on new segregated fund investments. He admits seg funds are pricey and attributes the high fees to the fact that AIC does not have the efficiencies of a regular life insurance company.

"We're a money management company not related to an insurance business," he said. "As an outside party there's more of a premium to get that type of insurance."

Dale Jackson is a producer

at Report on Business Television.

Overpaying over time

'Most markets won't see a negative return over [a 10-year] time span. So if you're playing the odds, the extra insurance is not necessary.'

MARK CHOW

ANALYST MORNINGSTAR CANADA

*****

Comparing premiums on segregated funds

FundManagement expense ration (MER)Segregated fund version (100%)
Dynamic FocusPlus Balanced2.57%9.81%
AIC Advantage II2.72%6.00%
TD Science & Technology2.79%5.97%
CI Explorere2.35%5.42%
Trimark Select Growth2.40%4.01%

SOURCE: GLOBEFUND

© 2007 The Globe and Mail. All rights reserved.

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