Investing in mutual funds: are they worth it?

Well, as I wrote before, Canadian banks offer very low interest for your money locked in any savings accounts with them. The best offer I heard of was some 3+ years deposit that offers about 2.5% of interest per annum. This is crap because you’re guaranteed to lose purchasing power if you lock your money for 3 years at this interest rate. And on top of that, you cannot take your money out, because all this hard-earned yield will evaporate if you choose to go away with your money.

This post is about mutual funds. What is a mutual fund? Well, you can read what it is here. But to make things really simple it is a form of investment that is designed for general public. Individuals buy shares of a fund with their money and this money is put into a shared investment account of the fund. Once there is enough money there a fund starts investing this money in some type of financial instruments which they normally tell you about in their hand-out materials.

If you come with your savings to a bank or investment company that offers mutual funds, you add your money to the account and fund manager deploys it to the same instruments fund is invested in. Then the manager gives you some shares that represent your claim on these investments. When you sell your shares back, a fund manager pays you the current value of your shares from a cash cushion and at the same time sells assets the fund has invested in to refill the cash cushion. If the investments made by the manager work well, the value of the share goes up and you have a paper gain. If a mutual fund invests poorly, the value goes down and you have a loss. If you sell your shares, your gain or loss materializes. It is worth mentioning, that fund has its operational expenses, managers, controllers and sales people. Regardless of what mutual fund you buy, 1-2% of the assets under management are disposed to cover these expenses every year. So your gain is cut by this amount. On top of that there could be some exit fees involved if you decide to leave a mutual fund.

I personally will be signing up for RRSP (pension saving plan) with an investment company next year and they will be investing in a basket of mutual funds. I do that not because I expect a good return, but for other reasons. First, it allows to reduce a tax base. Second, Amazon as a company matches your contribution (3% of my salary) and in two years this money will be available to me. So, even if the RRSP shows 0% gain, in 2 years it will be double the amount I put in. Unfortunately, this is the only choice the company gives: either to sign up, or they will not contribute to any other saving vehicles I might prefer…

Mutual funds are popular and wide-spread in North America because people normally have some savings and they don’t like the interest rate offered by banks. At the same time they either have no idea how to invest or have no desire to invest themselves. You can also find some similar investment vehicles in other countries, in Russia they are called PIFs. I would argue that it could be a good idea for a regular employed person to invest in mutual funds on a regular basis if you choose the right time to join. Let me explain why and how to choose such a moment.

The main problem with mutual funds (among others) is that they are subject to broad market risks. If the whole stock market plunges by 30-50% over couple of years like in 2007-2009, I promise you, any mutual fund will show a significant loss. Even if a mutual fund invests 100% in long-term bonds, a sudden interest rates hike (they are currently at the rock bottom) will significantly harm their investments. This happens due to a simple fact that funds are not allowed to short any asset. They are only allowed to go long or stay in cash. And in periods of broad market corrections you don’t want to be long any stock regardless of geography. Markets all over the world are highly correlated with the US market anyway, so even the broadest diversification will not save the day.

So, the best time to join mutual funds is a complete economic bust. When the economy is contracting, the stock market is more than 20% off its previous peaks and the economic outlook is negative… The bankruptcies are happening here and there every quarter, fancy restaurants are closing down, consumer sentiment is negative, the unemployment is raising, the central bank tries to doctor the economy… That’s an ideal environment for you to consolidate your cash under your mattress. Once the panic goes away, market stabilizes… That’s an great time to take your money and invest in mutual funds if you don’t know any better. If you do so, the asset valuations will be at better levels and the downside risks are much lower and therefore, regardless of how talented the fund manager is… your odds to make a good profit are high.

There is a word of caution though. Don’t try this in an environment when you’re not quite sure whether your country will still be there or not in a couple of years. If this is under serious question, you would be better off ‘investing’ in other stuff like canned food, guns and ammunition 🙂

If you wish to join bond funds, you might have to wait a long time for a good entry moment because you want to join in the environment of high interest rates. If the rates are at lows, say 20-year US treasury bond offers you 2.5% return per annum, the bond price will collapse by almost 50% should the rate rise up to 5%. This might be really problematic because central banks keep interest rates at lows for many years now and interest rates will eventually go up, but nobody knows when.

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6 Responses to Investing in mutual funds: are they worth it?

  1. Not sure I got it. Probably I lack some basic knowledge, can you elaborate more on “20-year US treasury bond offers you 2.5% return per annum, the bond price will collapse by almost 50% should the rate rise up to 5%” – why it so? I thought that bonds are sold with fixed interest rate, why it would change? And if it changes – like, increases, why bond price goes down? The higher the rate – the more you get, no?

  2. Well, I will explain it below.

    Of course, you will get more, if you buy new issues of bonds that pay higher coupon (5%). But older issues will remain at 2.5%. Given that nobody actually holds these bonds for entire 20 years period your manager will have to sell them at some point. Since everyone buys these bonds based on the coupon rate it pays, guess what you will have to do to convince buyer to buy 2.5% yielding bond from you when he or she might buy the same type of bond yielding 5% per annum?

    Well, you will have to give a discount of about 50% to original notional value of the bond you try to sell 🙂

    That’s why existing bond portfolios will get a serious hit if interest rate goes up even by not that much. Makes sense?

    • Share price of every mutual fund is calculated based on current liquidation value of its assets. Since the current liquidation value of 20+ year bond will collapse about 50% (if the rate is up to 5%) your mutual fund shares will drop in price according to a share of their long-term bond position.

      • Yes, now it makes sense. The only question is – how to know that it’s time to buy 🙂 There are a lot of bonds, not only U.S Treasuries, all with different interest rates. Seems that I need to read more on topic.

        • Well, you can buy corporate bonds and there are many mutual funds investing in these bonds as well. But US treasury bonds are benchmark. If their yield goes up, all corporate bond yields will go up as well because USTs are supposed to be less risk than any corporate bond nominated in US dollars.

        • Well, noone knows precise time to buy. That’s a risk part of this game 🙂

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