The Globe and Mail
Reprinted without permission

On Mutual Funds
by Duff Young

Why mutual fund substitutes are all the rage

OFFICIAL sales figures are not yet available for the RRSP season, but indications are strong that this year's grab will be much smaller than expected, despite continued low interest rates, a healthy economy and big ad spending. Some are guessing that a 30-per-cent decline from last year is possible.

The softness indicates that for the first time in seven years or so, educated investors are choosing to put less of their money in mutual funds and more in other newfangled savings vehicles.

The trend is good and bad. It reflects consumer attitudes about our industry - and provides some incentive for re-examining the way companies, design and market mutual funds.

There's always been a fringe element of investors who are so skeptical about any one manager's ability to beat the market that they invest in an index. But recent shifts have made this alternative notion of passive investing more. mainstream.

Unmanaged, or passive, mutual fund substitutes could be a good idea for a core part of your portfolio.

Evidence that stock pickers are struggling can be found in every category. Data on Canadian equities, for example, show that 84 per cent of the actively managed funds failed to match the 17.8-per-cent annual return of the TSE 300 index over the five years ended Jan. 31.

Adding insult to injury, and perhaps explaining part of the underperformance, are management fees. After all, there aren't any management fees to deduct from the index before you figure out its return. But mutual funds in Canada have high annual fees, and they're rising. (Remember, mutual fund returns, by law, are always calculated after annual expenses are deducted.) Take load funds. In 1992, the average management expense ratio for stock funds based in Canada was 2.28 per cent. Today, the same group has swelled enormously, but despite the growth, and the obvious economies of scale it should create, annual fees on these funds have actually gone up - to almost 2.40 per cent annually.

Eroding confidence further is the weakness in some of the industry's top names. Once-stellar funds from well-known families are now sporting bottom-quartile returns. So if investors can't count on the established stars to at least do better than the pack, what can they count on?

Here, then, is a list of the best passively managed alternatives to mutual funds. Each offers the diversification and pooling you've come to know and love mutual funds for. But instead of being guided by a stock picker trying to beat the market, these unique "funds" try only to be the market.

• TIPS are stock-exchange-traded units in a basket of companies that make up the TSE 35 index. They charge no annual expense ratio, but you have to pay a commission when you buy and when you sell. Financial advisers are recommending TIPS more and more often - especially outside an RRSP - because the stocks held are seldom changed, meaning there's very little chance of incurring much of a capital gain during the time you hold the units.
• International iShares (formerly WEBS) are shares traded on the American Stock Exchange representing holdings in bellwether companies from 17 different countries around the world. The United Kingdom WEB, for example, holds 98 of Britain's largest companies. The performance in 1997 for the UK WEB was 20.75 per cent, just a whisker shy of the return for the Morgan Stanley Country index that it mimics. They, too, have a low expense ratio - 1.22 per cent - and are available through any broker.
• Target 10 Trust is one of the most interesting index-like products available. It's technically a mutual fund but pursues the "Dogs of the Dow" approach made famous by Barron's magazine earlier this decade. Instead of a manager, this fund has a strategy that involves simply owning the 10 highest yielding of the 30 stocks that make up the Dow Jones industrial average. Remarkably, these high-yielding bellwether shares have provided immense protection from market downturns in the past 30 years - and have actually beaten the Dow over time. The fund charges 1.15 per cent in annual expenses, which is less than half what its rivals charge. You'll have to ask your adviser for this one because First Trust Advisors, the company that offers the fund, isn't well known. First Trust also offers a slew of similar passive funds for only 1.15 per cent in annual fees, like a Pharmaceutical Trust and a play on the oh-so-popular wealth management industry in Canada.

Even a skeptic would agree that some managers can clobber their benchmark - the trick is finding them. So don't put all your money in a passive strategy. Consider active management for some parts of your portfolio, like Canadian smallcapitalization holdings. There you'll find many standout managers. It's one more way you can achieve balance in your portfolio, and still keep overall fees down.

Duff Young, is president of FundMonitor.com Corp., which offers an independent portfolio repair service.