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Active Fund Performance At A Passive Price

Frugal investors are often attracted to index and exchange traded funds because they offer a simple way to buy a diversified stock portfolio at a low cost. But there are other options for thrifty individuals who want to take a more active approach.

I explored the money-saving possibilities of buying stocks held by index funds instead of the index funds themselves in the May 2008 edition of the Canadian MoneySaver. This month, I'll investigate a similar method for active funds where the potential savings can be much higher.

Here I focus on active mutual funds that might appeal to long-term investors. Such funds typically don't trade frequently (or have low turnovers) and are relatively concentrated. Concentrated funds hold only a few stocks and are markedly different from the index.

The main advantage index funds have over active funds is their low fees. For instance, the popular TD Canadian Index eFund charges an annual fee (or MER) of 0.31%. Compare that to the TD Canadian Blue Chip Equity Fund which has an annual fee (or MER) of 2.25%. That's more than seven times the cost of the index fund. Let's convert those percentage figures, which may at first glance appear to be low, into dollar amounts. On a $100,000 portfolio, a 0.31% annual fee comes to $310 whereas a 2.25% annual fee costs $2,250. That's a fee difference of $1,940 each and every year. Even worse, the dollar value of the fee grows as the portfolio grows. I don't know about you, but that sort of scratch buys me a nice vacation each year.

But the low-cost argument doesn't sway everyone. Some investors are keen on trying to outperform the market. But broad index funds are practically guaranteed to underperform the market slightly. That is, investors can expect them to generate market returns less the small fee they charge.

I'll dodge the arguments that index investors use to try to convince their active brothers to join in the passive fun. (At least in this article.) Instead, I want to see if we can get active fund performance without the big fees.

It turns out that you can in some cases if you're willing to build your own portfolio using the help of a fund manager. You see, funds must publish a list of their top holdings each quarter for all to see. You can find this list in the Management Report of Fund Performance (www.sedar.com) or on the fund's website. Even better, these reports are free of charge.

Let's consider a concrete example by examining the Mackenzie Ivy Canadian fund. This fund is a good candidate because it charges a relatively high annual fee (MER) of 2.35% but holds a concentrated portfolio that changes relatively infrequently. At the end of 2007, the fund's top 25 holdings represented 97.5% of its portfolio and its top 10 stocks made up 51.9% of the fund. The fund's portfolio turnover (also revealed in its performance report) was only 3.8% last year. (That's quite low because a 100% turnover rate is equivalent to buying and selling the entire portfolio once a year.) You can replicate most of this fund (51.9%) by buying only 10 stocks. You can almost fully approximate it (97.5%) buy buying 25 positions. Because the fund typically doesn't change much, you are unlikely to have to make many trades from quarter to quarter or even from year to year.

How does this save money? A $100,000 investment in the fund costs 2.35% annually or $2,350 per year (assuming that the fund doesn't grow). On the other hand, buying the top 10 stocks using a broker that charges $10 per trade costs only $100 in commissions. Buying 25 stocks costs $250 in commissions. Let's say the Ivy Canadian fund changes about 20% of its portfolio per year which is close to its 6-year average. That means you'll have to make, very roughly, 4 trades a year if you want to track the fund's top 10 stocks and 10 trades for the top 25. In dollar terms, that's an extra $40 or $100 in commissions a year. Overall, you're looking at a one-time portfolio setup fee of $250 in commissions to track 25 stocks and about $100 in commissions a year thereafter to track the changes. That's a great deal less than the fund's annual $2,350 fee.

Perhaps you'd like a little diversity? Why not nick the top ten picks from five of your favourite fund managers? If your broker charges $10 per trade, it would cost $1000 a year in commissions (assuming a 100% turnover rate) to buy, and sell, the top 50 stocks each year. That's still half the cost of a 2% annual fee on a $100,000 portfolio. The math gets even more attractive for larger portfolios. After all, a 2% fee on a $500,000 portfolio comes in at $10,000 per year.

This cost-cutting method doesn't work well in some circumstances. If you have a relatively small portfolio then it might be hard to cost-effectively buy 10 or 25 stocks. If the fund manager you want to track trades frequently then it may be impossible to keep up with all of their trading. Similarly, funds that hold hundreds of stocks are more costly to replicate.

On the other hand, it is relatively easy to poach the top 10 stock picks of a fund and avoid the big fees. Also, you don't have to limit yourself to funds offered in Canada. You can use the same method to buy stocks held by famous U.S. fund firms that may be hard for Canadians to invest in. For instance, the top 10 stocks in Bill Miller's Legg Mason Value fund represent about 47% of the fund's assets and the fund's annual turnover is near 11%.

But the most famous investor who is frequently aped by individual investors is Warren Buffett. Indeed, a recent academic study indicated that if you had bought the publicly traded stocks that his company (Berkshire Hathaway) bought, you'd have bested the index by a significant margin over the years. Of course, you could just buy Buffett's company directly, but that's another money saving way to buy active management that I'll discuss more thoroughly in a future article.

If you're interested in active money management at an index-like price, then consider building your own active fund by simply tracking managers that you admire. It does require more effort, but frugal investors should be more than happy to do a little homework to save thousands of dollars a year.

First published in the June 2008 edition of the Canadian MoneySaver.

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