As your bank will happily remind you, early in the New Year is still a great time to contribute to your RRSP and receive tax credits for the previous tax year. In 2014, the deadline is March 3rd to get credit for the 2013 tax year. As always, financial advisors are banging the drum to contribute something, anything, into your RRSP because every penny counts and the power of compounding can’t be beat. Earlier is always better.
Like a flock of sheep, each year Canadians trundle off to the bank to open an RRSP or contribute to their already-existing RRSP account. At which point one of two things typically happens. First option, the Canadian investor hasn’t had time to think about what they want to invest in, and wants to be ‘safe’ with their investment until they can decide. In which case the investment typically sits in an daily interest savings account, currently paying about 0.25% (with maybe a little two or three month bonus of 2% as an enticement during RRSP season) or it is invested into a GIC. Big bank GICs are equally abysmal, currently paying out under 1% interest per year unless you’re willing to lock in to a 5-year non-redeemable GIC which might pay you all the way up to…1.75% interest. Be still my beating heart!
The second thing that typically happens is the Canadian investor sits in an office with the bank’s designated financial advisor and completes an investment risk tolerance questionnaire. If I might digress here just for a moment, I would like to point out that the term ‘financial advisor‘ has absolutely no specific meaning or qualification associated with it. In the big banks, it typically means someone who has been trained how to run the computer that administers the risk tolerance questionnaire and then sell you whatever the computer recommends you invest in. Seriously. So you work your way through the risk tolerance questionnaire and at the end, the financial advisor will tell you that you are best suited for the one of the big bank’s managed portfolios. It may be a conservative portfolio, a balanced, or a growth portfolio, but it will undoubtedly be a managed portfolio account.
So what does it mean to invest in a portfolio account? It essentially means you are buying a mutual fund that consists of a whole bunch of underlying mutual funds. Presumably you’ve already heard that in Canada mutual funds are considered expensive because of their MERs – management expense ratios. Well, here’s a secret the bank financial adviser will not share with you – portfolios of mutual funds are even more expensive because they have to pay the MERs of all the underlying mutual funds as well as an additional MER for managing and rebalancing the portfolio itself. So if the weighted average of the MERs for the underlying mutual funds totals 2.4%, in all probability the MER for the portfolio fund will be closer to 2.6 or 2.7%.
As an example, I took a look at a CIBC managed portfolio fund. Note, I’m not picking on CIBC here, all the big banks have these sorts of portfolios. I wrote about my experience with the Big Green Bank (yes, I’m looking at you TD) earlier, in which I was trying to buy individual index mutual funds but the bank’s computer was determined instead to sell me a portfolio fund.
So, back to the CIBC portfolio fund. The one I analyzed is called the CIBC Managed Balanced Porfolio. Now, as funds of funds go, balanced is often a good idea as a set if and forget it option. What’s not so good in practice is how much you will pay for that peace of mind. Bear in mind that this balanced portfolio, as with most, is intended to hold 50% fixed income and 50% equities (growth). Fixed income investments are cheap, in general. So they should contribute little to the cost of the fund. Equities cost a bit more, but a good index fund can usually be had for a MER close to 1%. So how much does CIBC charge for this managed balanced portfolio they are offering you? The MER is listed at 2.24%. But that’s not all. In addition, there’s a Trading Expense Ratio (the manager does need to keep the portfolio within its intended balance you know) of an additional 0.08%. So all in, this managed balanced portfolio’s expenses total 2.32% per year. That means for every $1000 you have invested in the fund, CIBC is going to skim off $23.20 per year for the privilege of managing your money. Even if the fund itself loses money in that year.
I did some analysis of the CIBC managed balanced portfolio and came up with a completely equivalent investment portfolio that you could set up by buying into specific CIBC index funds in the same asset classes and percentages as are represented in the portfolio fund. Want to guess what the management expenses would be for the equivalent do-it-yourself (DIY) portfolio? The answer is: 1.18%. Or $11.80 per year. That’s right, it would cost you less than half as much to achieve the same (or likely better due to reduced drag on performance from compounded costs) performance by buying individual low-cost mutual funds as taking the bank computer’s recommendation for a portfolio account.
An even easier option is to look at the CIBC offerings in index funds. Lo and behold, CIBC offers a CIBC Balanced Index Fund with a MER of 1.18 and total fund expenses of only 1.22%. This is the easiest possible ‘set it and forget it’ low cost option.So you can achieve the same level of risk/return (CIBC rates both as Low to Medium) for a full percentage less in management fees per year. Not only that, but the return has been better. I would caution here as the banks always do in the fine print, that past performance may not be reflected in future returns. But the CIBC managed balanced portfolio over the past ten years has achieved an unimpressive annual compound return of 3.7%. The CIBC Balanced Index Fund over the past ten years has achieved an annual compound return of 5.6%. Again, why would you pay extra for the managed portfolio?
So the next time a bank financial advisor tries to sell you on a managed portfolio fund, ask if they have an index fund equivalent. Better yet, do just a bit of research and find the bank’s index fund equivalent to the managed portfolio and insist on buying the less expensive option. Of course if you do that, the bank won’t make nearly as much money off your investments. Too bad so sad for the bank.
In a future post, I’ll explain how to do your own breakdown of a recommended portfolio and build your own DIY portfolio of individual mutual funds that are even less expensive than a balanced index fund. That takes a little more ongoing maintenance for your account, so if you are just starting out and want the absolute simplest couch potato option, find a balanced index fund, stick all your investment money there, and forget about it.