October 2010


Why high net worth investors
should give mutual funds a second look

By Don Eberley


"Whenever you find yourself on the side of the majority,
it is time to pause and reflect."

- Mark Twain




Most high net worth investors did not accumulate their wealth by following the crowd.   When it became fashionable to run up a line of credit on hot tubs and SUVs, for example, they were living quietly within their means, paying off debt and saving money.   They followed their own course.

But then a funny thing happened.   As their investment portfolios grew to $150,000 and beyond, pressure started mounting on high net worth investors to join a new crowd, and hire a stock broker who could build them a "real" portfolio of stocks and bonds.   Mutual funds were suddenly for other people.

But is this true?   Should mutual funds really be abandoned as soon as one has enough money to open a brokerage account?

Having worked professionally on both sides of the fence - the brokerage side and the mutual fund side - I believe that the financial establishment has done high net worth investors a great disservice by pushing stocks and bonds over mutual funds.   There are a number of reasons why high net worth investors should question this advice, and give mutual funds a second look.



1. JOIN THE RESISTANCE

Canada has become a nation of taxation, particularly for the upper middle class.   The mere scent of taxable interest income, dividends or capital gains brings the sound of the tax man's heavy footsteps to your door every time.

Fortunately, a resistance of sorts has developed in recent years.   It comes in the form of Capital Class and T-Class mutual funds, which allow high net worth investors to shield their taxable investments in ways which conventional stocks and bonds cannot.   Examples of what you can now do include:

- Rebalancing and even replacing entire investments without realizing capital gains
- Generating low-risk, bond-like income that is taxed at the lower capital gains rate
- Redeeming the principal portion of an investment before the profit, when tax deferral is needed
- Preserving OAS benefits in the medium-to-high income range, by making income non-reportable

This "resistance" is all about protecting income that would otherwise be lost to the tax man, and is available to mutual fund investors only.



2. SIMPLIFY YOUR LIFE

Whereas tracking the taxable gains and losses of a stock portfolio can be a bookkeeping nightmare, with a mutual fund the math is consolidated to the portfolio level.   One book value.   One market value.   And a simple, one-page report which provides everything your accountant needs at tax time.

Another bookkeeping benefit is that management expenses are pre-deducted from your reportable gains. Not only does this make performance reporting more realistic, but it also ensures that you will never miss this important deduction.



3. GO WITH PROVEN STUFF... NOT COCKTAIL PARTY BLUFF

The performance track record of a stock broker is difficult to assess.   The only third-party information generally available is whatever you can glean from late-night cocktail party conversations.

Mutual funds, by contrast, have clearly-documented performance records that you can review by the light of day.   Contrary to popular wisdom, past performance does say something about a manager's abilities, if it can be observed over multiple economic cycles.   I will take track record over a martini-soaked endorsement any day.

The credibility of a mutual fund grows even larger when it is powered by independent research, away from Bay Street and its back-room dealings.   And when it comes to foreign investing, currency hedging, derivatives and other specialized areas, mutual funds are pretty much the only place to turn for proven expertise.   Few stock brokers are qualified in these areas.



4. FIND STRENGTH IN NUMBERS

Because a mutual fund combines the wealth of many into a single portfolio, it pays lower transaction fees on stocks, and gets a better price/yield on bonds, than is generally available through a full-service brokerage account.   And it occasionally has access to new issues, inflation-protected bonds, and other goodies that may be unavailable to individual investors at any price.

A mutual fund also carries more weight with the companies it owns than most individual investors do.   While you might have, say, ten thousand dollars to invest in a single company, a mutual fund might have ten million.   It doesn't take a fortune teller to predict whose phone calls the CEO will return first!

Perhaps most significantly of all, mutual funds can use proxy voting (the pooling of many shareholder votes) to influence a company's direction.   In one prominent example, mutual fund giant Mackenzie Financial took a stand against one of its own investments, when the company in question announced plans to sell a division to a low U.S. bidder despite the existence of a higher bid from within Canada.   This was done in the interest of maximizing value for Mackenzie unit holders, and it gives new meaning to the phrase "active investing".

Capitalism, meet Democracy.



5. BE INVISIBLE

Because mutual funds do not give you direct ownership of the companies in your portfolio, you are generally free from U.S. estate taxes, insider-trading restrictions, and other potential liabilities.   Some very wealthy investors choose mutual funds specifically for this reason.

A further benefit of indirect ownership is privacy, because your name does not appear on any shareholder lists.   The privacy of shareholder lists has long been a contentious issue, as more than one investor has found his or her name being revealed to various parties as a result of appearing on a list.



6. IMPROVE THE RELATIONSHIP WITH YOUR ADVISOR

Although $150,000+ is a lot of money to invest, on a stock broker's commission grid it doesn't necessarily put you anywhere near the top of the heap.

Canada's leading stock brokerage firms deal in very large volumes, and are naturally focused on the needs of their most affluent clients.   And that's a shame, because it's not just the Trumps who need advice.   Most high net worth investors, particularly as they enter retirement, require help managing complex portfolios, multiple income streams, tax issues, estate planning, and other matters.

If your broker makes you feel like a small fish in a big pond, consider switching to a mutual fund representative who works from a private office.   He or she probably enjoys a less volume-oriented compensation plan, and can afford to give your plan the attention it deserves.



THINGS TO KNOW ABOUT MUTUAL FUND INVESTING

There is no perfect investment, and it would be wrong of me to sing the praises of mutual funds without mentioning their limitations.   In addition to the standard legal disclaimers, you should also keep the following in mind about mutual fund investing:

- The potential for year-end tax distributions needs to be assessed before placing new money.
- Tax-deferral funds are never 100% perfect... some taxes are going to hit you along the way.
- Tax-deferral funds usually cost a bit extra, and are therefore less suitable for lower tax brackets.
- Tax-loss selling opportunities at the investor level are quite limited... cannot sell individual stocks.
- Some mutual funds charge active management fees for index-like performance. Avoid them.
- Some mutual funds are flavour-of-the-month marketing gimmicks. Avoid them.

Please drop a line to don@doneberley.ca if you would like to discuss giving mutual funds a second look for your portfolio.   I welcome your business!


DE