The mutual fund industry is a mature industry that remains extremely profitable despite overwhelming evidence suggesting that alternative options such as exchange traded funds (ETFs) are far more beneficial for investors. Although mutual funds continue to have their market share eroded by ETFs, the fact that the assets in mutual funds continue to grow, and that profit margins continue to stay stubbornly high is absolutely astounding. Kudos to the extremely well-paid marketing executives in the mutual fund industry who continue to employ deceptive sales tactics and manipulate statistics to their advantage to keep the party going!
Today we are going to take a closer look at one of the greatest sources of mutual fund profits: The Balanced Fund. Balanced Funds come in many shapes and varieties, and are pretty much offered by every mutual fund company other than tiny companies who specialize in a particular asset class. Balanced Funds are an easy sell for mutual fund companies because they offer good diversification and are a simple one-ticket item for overwhelmed investors who prefer to keep things easy to manage.
Over the past decade or a bit longer, wrap funds have become extremely popular, positioned as diversified “all-star” funds. Each wrap fund owns a number of distinct underlying funds (sometimes overlapping), but from the consumer’s perspective, they are only buying one fund. Simple. Easy. But make no mistake, wrap funds are just modern versions of traditional balanced funds which hold individual securities.
The balanced fund will have exposure to a number of different asset classes. In Canada, you will typically get exposure to bonds, Canadian equity, U.S. equity and International equity in various proportions defined by the asset allocation policy for the balanced fund. If you look at a “conservative” balanced fund, you may have the majority of the fund allocated to bonds, whereas the equity components would dominate in an “aggressive” balanced fund.
There is no better way to illustrate the rip-off than by looking at an example. I don’t want to pick on anybody in particular, so let’s just say that we will look at the balanced fund of a Big Blue Bank or BBB. The BBB Balanced Fund is one of the largest in the country with $5.8 billion in assets, and it states that its asset allocation policy is 45% Bonds, 35% Canadian Equity, 10% U.S. Equity, 7% International Equity and 3% Emerging Markets Equity.
Conveniently, Big Blue Bank also sells the following funds: BBB Bond Fund, BBB Canadian Equity Fund, BBB U.S. Equity Fund, BBB International Equity Fund, and BBB Emerging Markets Fund. I went through the painstaking process of separating the holdings of the BBB Balanced Fund into its five components and found that the holdings of each component were remarkably similar to the holdings of each corresponding individual fund! So in theory, you could create your own BBB Balanced Fund by purchasing the five individual funds in the same proportion as the asset allocation policy of the BBB Balanced Fund.
Before we run a comparison of these two options, we should point out that the asset allocation policy is only a guideline, and that actual allocations to each individual asset class will vary and depend on a number of factors. In particular, BBB controls the asset allocation of the Balanced Fund and may attempt to enhance overall Fund returns by actively investing in a manner different from the asset allocation policy – such a strategy is often referred to as tactical asset allocation (or market timing). For the “build-it-yourself” model, asset allocation will be the responsibility of the builder, not BBB. Most empirical studies show that market timing does not add value over long periods of time, but pretty much every single active investment manager will dispute it anyways.
Looking at data obtained for June 7, 2016, we can take a weighted average of the performance and fees associated with the build-it-yourself model and compare them to the balanced fund option:
| Fund | Allocation | 3-Year Return | 5-Year Return | MER |
| BBB Bond Fund | 45% | 4.08% | 4.44% | 1.22% |
| BBB Canadian Equity Fund | 35% | 6.86% | 3.34% | 2.06% |
| BBB U.S. Equity Fund | 10% | 13.67% | 12.49% | 2.10% |
| BBB International Equity Fund | 7% | 10.94% | 9.09% | 2.26% |
| BBB Emerging Markets Equity Fund | 3% | 8.29% | 5.01% | 2.43% |
| Weighted Average | 100% | 6.62% | 5.20% | 1.71% |
| BBB Balanced Fund | 100% | 6.56% | 4.88% | 2.16% |
Source: Morningstar Direct. Return data is presented on an annualized basis.
We mentioned earlier that it is easier for a sales rep to sell one fund rather than five, and the investor is rewarded by paying a 0.45% PREMIUM – how wonderful for the mutual fund company! Looking at the performance shows that over 3 years and more importantly 5 years, in both cases the investor would have been worse off with the balanced fund! But BBB knows that most investors would not perform this analysis, so they are happy to charge an extra 0.45% on a $5.8 billion dollar fund – that works out to a cool $26.1 million in extra profit for the bank EVERY YEAR!
Pretty disturbing isn’t it? And it’s funny that the people who sell balanced funds don’t mention anything about the extra fees or worse performance during the sale. Our example focused on the big blue bank, but most other companies that sell mutual funds are guilty of the same tactic – perform this same analysis for yourself and see. It just one more reason why it is time to stop being ripped off by self-serving salespeople and financial institutions and time to move to a company who treats their clients justly!
Written by Andrew Kirkland, President at Justwealth
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