Mutual Funds vs. Direct Investing

Nowadays, it’s hard to avoid the temptation of mutual funds.

We see advertisements for them everywhere. There’s a large billboard for a large mutual fund dealer that I pass by every day on my way home from work. And for a lot of people, the attraction is validated– it’s a managed product, meaning that you have to do little or no work, and a lot of them still generate attractive returns.

But with all the buzz about mutual funds in popular culture, I find that people often forget that there is even an alternative. In the good old days, people would go to their broker and instead of telling them to invest in a fund, they would buy shares of Wal Mart or McDonald’s.

To help my readers make their decision on whether to invest in mutual funds vs. direct investing, I’ve written this post detailing the pros and cons of each. And before you ask – I am in the direct investing camp. After reading, you’ll know why.

Before I go into the pros and cons of each strategy, I thought I would start first with some definitions just so I don’t lose any readers in the jargon along the way.

What exactly is a mutual fund?

A mutual fund is an investment product where investors pool their money to be invested in securities and managed by a professional. Mutual funds are manufactured by companies like CI Investments, Mackenzie Investments, and all the Big Five Banks.

You can buy mutual funds to invest in a variety of asset classes – there are equity (stock) mutual funds, fixed income (bond) mutual funds, balanced (a mix of stocks and bonds) mutual funds, along with a variety of other asset classes.

There are also mutual funds that invest in particular strategies within those mutual funds. For example, within equity mutual funds you could invest in a fund that buys stocks with a “dividend growth” strategy – buying stocks that pay a good dividend now but have even better prospects for raising that dividend in the future.

When you invest in mutual funds, you don’t buy stocks like you do when investing in companies like Apple or Google. Instead, you purchase “units” of the fund. Fractional units are also available, which allows investors to purchase the exact dollar amount that they want. This is not the case with stocks. If ABC Inc. is trading at $25, you can’t invest $30 in the company’s stock unless the stock price changes.

For their services, mutual fund providers collect a variety of fees which are typically expressed as a single number for the purpose of simplicity. This number, called the Management Expense Ratio (“MER”), is expressed as a percent and basically means “how much of your investment is being paid per year for investing in this mutual fund?”

Now that we’ve got the fundamentals out of the way, let’s talk about the actual arguments of mutual funds vs. direct investing.

Mutual funds might be a good fit for you if:

You’re at the beginning stages of your personal finance journey. If you’re new to investing but think you might want to participate in the stock market later on, then mutual funds might be a good place to park your money until you feel comfortable enough to buy particular shares of individual companies. Mutual funds are great because for a small fee, you have access to an expert money manager so you know your capital is being managed in a safe way.

Your portfolio is currently on the small side. Mutual funds are different than self-directed investing because they don’t charge you fees on a transactional basis. Instead, you pay a percentage of your assets under management (“AUM”) to the fund management annually. Transaction costs in self-directed brokerages are different because they charge you per trade. If you trade a lot or have a small portfolio, these fees will quickly eat away at your investment returns.

You don’t have an interest in learning about the stock or bond market. I know what it’s like to try and learn about something you don’t like a lot. In my first year of university, I was a biology major and though I didn’t like it very much, I trucked on until switching to a Mathematics & Statistics double major in my second year.

Learning about Chemistry and Biology was boring, and hindered my overall academic performance. My point is – you can’t really fake an interest in something. I can’t imagine how stressful it would be if I had money on the line like you do in the stock market, without having an interest in the stock market. Good thing I like finance!

You’re too busy to manage your own investments. No matter how much you love finance, if you don’t have the time to learn about it then you’ll never be successful in the stock market. Every time you buy an individual stock, the transaction should involve a significant amount of analysis and due diligence – that way, if the price starts behavior bizarrely then you can still feel confident in your investment.

It’s also critical to take the time actively monitor your investments if you’re buying individual stocks. This isn’t the case so much in mutual funds, since that’s what the fund manager is being paid to do.

Self-directed investing – The alternative

Self-directed investing is the alternative to mutual funds, and I’m part of the camp that believes in self-directed investing because it allows you to save on fees, learn about finance, and potentially post market-beating returns.

As a competitive, type-A person, I like the fact that if my portfolio fails it’s my fault rather than due to some fund manager that I’ve likely never met. There are also a slew of other benefits for self-directed investing done right. Self-directed investing might be the right choice for you if you possess any of the following characteristics:

The will to win. I firmly believe there is a correlation between competitiveness and direct participation in the stock market. I’ve already touched on this, but I’ll say it again – it’s really nice to know that your portfolio’s performance is due to you and you alone.

Given that most active mutual fund managers tend to underperform their benchmarks after fees, it looks like the odds are stacked in our favour!

An interest in finance and the capital markets. Everyone has something that makes them tick and that they are truly interested in. For me, it’s definitely finance. That’s why I write this blog, and that’s why I participate in self-directed investing. There are definitely topics, however, that do not interest me in the slightest.

For example I absolutely hate grocery shopping. That’s why I prefer to let anyone else in my house perform this task. If that’s how you feel about the stock market, then self-directed investing is not the solution for you.

A bit of free time. Although it doesn’t seem like much because I enjoy it, I still have to spend some time every week checking into the capital markets and seeing how my investments are doing. This is generally for two purposes. First, I need to be aware of when to cut my losses if any of my holdings are tanking.

You don’t want to be the guy who only tunes into the stock market every six month. If you had bought Valeant Pharmaceticals last August and checked back in March, your stocks would have dropped from $346 to $37. OUCH!

The second reason why you need to keep in touch with your portfolio on a regular basis is for the purpose of rebalancing. As I mentioned in our guide about Principles of Personal Finance, a moderate amount of diversification is key to the long-term success of any investment portfolio. If Stock A is up by 50% and Stock B is down by 50%, then obviously Stock A is going to have a greater portfolio allocation then intended and Stock B is going to have a smaller piece of the pie than you’d like. Time to rebalance!

Extreme levels of frugality. Like it or not, the mutual fund industry is an expensive way for the retail investor to gain access to the capital markets. Just because that 2% management expense ratio (“MER”) isn’t explicitly charged to you, it still eats away at your investment performance each year. MERs by nature are become more detrimental the larger your portfolio becomes – while self-directed trading costs are fixed, and can be negligible in a big enough account.

Let’s say you have $100,000 to invest and have a choice between retail mutual funds or self-directed investing. With a 2% MER, you’re going to spend $2,000 per year in management fees for the mutual fund. TD Direct Investing and RBC Direct Investing charge $9.99 and $9.95 per trade, respectively, so let’s say $10.00 per trade for a nice round number.

With the management fees you’d be paying in a mutual fund, you could make 200 transactions in a year with self-directed investing.That’s a lot of trading power! Now extend this logic to funds with even higher fees – I’ve seen mutual funds with MERs as high as 3%! My point here is that once your portfolio reaches a certain size, you’ll save a lot of money on fees if you’re willing to take the approach of a self-directed investor.

Your risk appetite means you want to trade on margin. Investing money in a margin account means that you are borrowing money from your financial institution to invest in the capital markets. Typically this happens with stocks, not bonds. The reason for this is because most margin accounts charge interest at a similar rate to an unsecured line of credit – typically around 4%.

Given that bond yields are at record lows right now (way below 4%), it makes zero sense to borrow money to invest in bonds.

Leveraging your portfolio through a margin account will increase your returns in a bull market and will exacerbate your losses in a bear market. Either way, I’ve never heard of a mutual fund that lets it’s investors use leverage, so if you’re interested in doing this then self-directed investing might be the choice for you.

That’s It!

And that’s really all I have to say about mutual funds vs. self-directed investing. I’ve said this before (both here and in other posts) but I personally participate in the stock market through self-directed investing. This post has likely given you a sense of why!

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