It’s not hard to find lots of popular shows about the secret lives of ordinary things. How about the secret life of mutual funds? Lately, it’s been no secret that mutual funds have come under fire in Canada, often for good reason. Poorly managed, they can be plagued by unclear fees, conflicts of interest, and cost and performance concerns.

But, before you abandon all mutual funds in your distaste for the bad eggs, let’s take a closer look at how much you really know about them. You might be surprised to discover some important advantages you weren’t aware of.

 

Historical Context

Ever since mutual funds were invented in the 1920s and popularized in the 1970s, they’ve been making it a whole lot easier to appropriately invest a little or a lot of money across wide swaths of our capital markets.

You can think of a mutual fund as being like a big pie. For each fund, or pie, its managers purchase a batch of underlying securities, such as stocks, bonds, and whatever other ingredients a fund’s “recipe” calls for. People like you and me can then buy and sell slices of that pie in the form of fund shares.

This makes mutual funds a practical way to invest in potentially thousands of individual stocks, bonds and other securities around the globe.

 

Three Good Things About Mutual Funds

Of course, there are other kinds of structures that work in a similar fashion, by pooling your money with other people’s investments and delivering a fair share of the earnings or losses to you. But there are a few significant advantages to mutual funds in particular. Most folks aren’t aware of them, even though they can be pretty important.

 

Three qualities cover them: regulation, transparency, and independence review.

  1. In part because they’ve been around longer than other similar structures (such as Exchange-Traded Funds), mutual funds are quite heavily regulated at the national, as well as the provincial or territorial level.
  2. As such, mutual fund managers must comply with strict “operating guidelines,” including being transparent with details such as their funds’ objectives, fees and real risks. This makes it easier for you to accurately assess any given fund, to determine whether it’s a good fit for you.
  3. Regulations also dictate several independent checks and balances to protect your assets. For example, each mutual fund manager must partner with independent service providers to perform various functions, such as accounting for, recording and holding onto the fund’s underlying investments. Mutual fund managers also face independent audits and reviews.

This trifecta of regulation, transparency, and independent review makes it more difficult for a good mutual fund to go bad … or to get away with it for very long if they do. In today’s risk-laden world, that strikes me as an important advantage indeed.

 

Identifying the Best, Avoiding the Rest

Of course, like any other product, some mutual fund are far better built than others. How do you know a solid vehicle when you see one? Thanks to those regulations I just mentioned, it’s all there in a fund’s legally required prospectus, or “owner’s manual” … if you know what to look for. Fair warning: A fund’s prospectus may take some translating to fully understand what all the fine print is really saying.

In any case, here are a few key questions to consider:

Will they stick to the plan? Just as you intend to manage your own portfolio according to a clear, consistent plan (right?), any fund you invest in should do the same. For example, say a fund is billed as helping you invest in international small-company stocks. But what if a close look at its prospectus reveals that it actually has wide leeway to flee to cash, lapse into large companies, or otherwise alter its make-up without warning? If so, the fund is far less likely to deliver as advertised, which can throw your own plans into a tailspin.

Is their strategy cost-efficient? Just as when you invest on your own, mutual funds can engage in more-, or less-efficient trading. They can decide to try to chase or flee hot or cold markets … or sight tight throughout. The “sit tight” approach is readily accomplished by tracking indexes or similar benchmarks that represent the portions of the market you’re seeking to capture. Properly implemented, this ensures money isn’t spent on efforts that aren’t likely to improve your outcomes anyway. If one of their goals is to instead try to “beat the market,” they can end up generating unnecessary fees, creating taxable turnover, and otherwise incurring extra costs without necessarily delivering higher returns to you.

Is their strategy crystal clear? Transparent communications matter too. Mutual fund managers must adhere to regulatory requirements, such as disclosing most fees and separating asset custody from asset management. But if you ask about the details, and the answers are confusing or hard to come by, this may suggest you’d be better off finding a provider who is better at explaining their business practices.

 

Basically, what I’m getting at is this: I suggest avoiding funds that pursue relatively opaque active management, instead of just cleanly and efficiently capturing returns from their stated swath of the market. As I explained in “How do markets work?” there’s ample academic evidence that argues against trying to time when to be in or out of the market, or pick this or that specific security. That goes for you. It also goes for your mutual fund manager. A fund manager’s time is far better spent efficiently achieving their stated investment goal, eliminating any unnecessary management expenses involved, and passing those savings on to you.

Speaking of sticking to stated goals, my goal is to keep these sorts of insights heading your way. So don’t forget to stay in touch, and I’ll keep the newsfeed flowing!