The Frugal Fund Way
At Frugal Funds we believe that investment success can be achieved by
following a low-cost long-term approach.
- Good Performance
- Good Portfolios
- Good Managers
- Low Management Expense Ratios
- Low Market Impact Costs
- Low Brokerage Costs
- Low Taxes
- No Loads
Costs matter and when it comes to mutual funds the fees are largely
combined into a fund's Management Expense Ratio or MER. To see how
fees affect performance consider an index fund with a MER of 0.5%
where the underlying index has risen by 10%. In this case the index
investor's return would be 10% less 0.5% or 9.5%. Similarly, if a
mutual fund charges a MER of 2.5% and its clever portfolio manager
gained 12% then the investor would achieve an annual gain of 9.5% (12%
The average equity fund charges a MER of about 2.5%, and, at first
blush, this rate might not seem to be very high. After all, until
recently, many fund investors were rewarded by returns of 20% and 2.5%
seemed like a small price to pay. However, under most circumstances a
2.5% annual fee is actually quite high. Let's consider investing
$100,000 in Fund A (with a MER of 0.5%) and Fund B (with a MER of
2.5%). In the next five years both funds gain the same amount before
fees and achieve annual returns of 10%, 5%, -5%, 15% & 0%. After the
five years, Fund A's investors take home $123,194 and Fund B's
investors get to keep $111,797. The 2% fee difference nets $11,397
more for the low cost investor!
Past Performance A Poor Guide
Most fund investors pick their funds by focusing on past performance.
Various mutual fund rating guides cater to this desire and use past
performance as their sole selection criteria. More advanced services
tweak things a bit by incorporating fund volatility or some measure of
performance consistency. However, in the end, it is all about past
prices. If a fund has done well then it is assumed it will do well in
the future and the role of luck is ignored.
Regrettably, past performance has long been shown to be a poor
predictor of future success when it comes to mutual funds. With the
aid of globefund.com I looked at the top ten performing Canadian
growth funds of 1999. All had achieved stunning gains of over 31% but
investing in them at the end of 1999 would have been a poor decision.
In 2000 eight out of ten of the funds did worse than average and only
two did marginally better. The ten 1999 winners fared even worse in
2001 (January 1 to December 7) with nine out of ten doing worse than
average. It should be noted that the one fund that did better than
average in 2001 was not one of the two that did better than average in
2000. This example provides just a taste of the evidence against
buying the best past performers and is illustrative of the dangers
associated with performance chasing.
Should performance be totally ignored? No, it turns out that really
bad performance is a fairly good indicator of unskilled management.
If a fund has been in the bottom 25% of performers with a high degree
of regularity then it is best avoided. Regrettably you can only weed
out about 10% to 15% of managers this way. One can cut out the truly
horrible managers, but it is hard to tell the difference between
mediocre and good.
Turnover and Taxes
Taxes are also a big issue for regular investment accounts. Consider
a portfolio manager who gains 15% annually before taxes over a
twenty-year period and pays 27% on realized gains. If they didn't buy
or sell a single stock in that twenty-year period then they would have
an after tax return of 15%. However, if they bought and sold their
entire portfolio each year then they would have achieved a much lower
return of 11% after tax. Tax minimization is a key advantage of the
buy and hold approach and is ignored by many actively managed mutual
funds. Recently funds have been forced to publish portfolio turnover
in their prospectuses. Lower turnover funds are generally better
performers because they trigger less tax and incur lower brokerage
|Initial Investment Compounded at a 15% Pre-Tax Annual Rate of Return
over a 20-Year Period, assuming a 27% Tax Rate on all Realized Gains|
|Pre-Tax Return||Annual Turnover||After-Tax Return|
|15% ||0% ||15.0%|
|15% ||3% ||14.4%|
|15% ||10% ||13.4%|
|15% ||30% ||12.0%|
|15% ||85% ||11.1%|
|15% ||100% ||10.95%|
When selecting mutual funds, investors should first minimize fees
which means low MERs and low turnovers. Furthermore, investors should
stick to no-load funds or buy load funds without the load through a
discount broker. Secondly, managers with a horrible long-term track
record should be shown the door. These factors form the core of our
approach, but, as with many investment approaches, implementation is
easier said than done. There are thousands of funds to choose from
and we spend a great deal of time weeding out the numerous high-cost
funds to provide a short list of the most attractive Frugal Funds.
Furthermore, the many tricks that funds use to disguise poor
performance, or to hide high fees, need to be avoided.
In the end, we believe that investors are much more likely to achieve
satisfactory performance by sticking to a low-cost long-term approach.
Although no one can guarantee future performance, our method has
worked admirably in 2002 with 75%
of Frugal Funds posting above average performance.