When Should You Dump Your Mutual Funds?

The 2016 RRSP deadline is fast approaching; that means large lump sum contributions for many. The majority of that money is allocated into debt (bonds) or a mutual fund. Most employee savings plans and pension plans directly buy mutual funds, but mutual funds are not necessarily the best choice for the average consumer due to their fees. As one's wealth rises, it may be ideal to move away from them, but when should you dump your mutual funds?

Firstly, what is a mutual fund? Essentially, they are professionally managed portfolios. They provide access to the bond and equity markets with minimal capital. In most cases, mutual funds do not charge for transactions. Instead, their earnings are made through a management expense ratio (MER) which is used to pay employee salaries, accountants, lawyers, and other operating expenses. These fees tend to be between 2-3% of the fund's net asset value. Although this amount seems small, these fees add up over time, and we are here to expose how much money is actually lost by retirement.

Let's assume you are contributing equal payments of $10,000 annually for 40 years into a mutual fund with an MER of 2.5%. We will also assume there is zero net growth in the fund to simplify the calculations. This means the fund's value rises equal to the MER and thus shows no growth.

In the first year, the MER paid would be $250 and in the 40th year, the MER paid would be $10,000. If you've forgotten the formula for this kind of arithmetic, it is (first year's MER plus final year's MER)/2 multiplied by number of years. We can see that the total MER paid by you is $205,000. While your retirement account is worth $400,000. The total MER paid is over 33.8% of your total wealth.

Of course, that's not all. Depending on the source, it is measured that in any given year, just one-quarter of all mutual funds will beat their benchmark. Over the long-term, less than 0.1% of funds outpace the index. In 2014, a report by Jeff Sommers, writer for the New York Times, concluded that just 2 funds out of over 2,800 beat the S&P 500 for five consecutive years (2009 to 2013). Both were small-cap funds, and thus, had a higher probability of beating the index. Unfortunately, both funds, in 2014, failed to maintain their run.

There is strong evidence to support that active funds cannot outperform an index, and this information is vital for investors looking to manage their own capital more efficiently. The alternative to mutual funds would be index funds, such as the iShares TSX 60, SPDR S&P 500, or SPDR Diamonds Index. MER's for these ETF trio are roughly 0.10%. Assuming zero net growth, the total MER paid over the same period is $8,200. If the index also grew by 2.5%, you would have an additional $196,800 at retirement, almost 50% more, by reducing your overall fees. These gains exclude potential capital appreciation and dividends, which historically yields 8% on average.

So getting back to the original question, when should you dump your mutual fund? Most self-directed registered accounts at a brokerage will charge up to $125 a year if the total equity is below a certain threshold. And trades on ETFs will run about $10. This translates into an annual cost of $135. Based on all that has been discussed, if your total portfolio exceeds $5,400, then it may be profitable to move your mutual fund into an index fund.

Many investors stick to mutual funds because they lack investment knowledge. Their lack of confidence or education persuades them towards products that are managed professionally, but as we see, spending just an hour a year educating yourself will pay significant dividends down the road. Even by simply making this transition, you will be 50% richer.

Minh Luu is a former Canadian investment representative with a major in finance. All advice and information in this article is opinion-based and is not a recommendation on buying or selling. Always speak to your investment advisor.