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Expensive fee structure makes balanced mutual funds a poor choice for most investors

by Wayne Cheveldayoff, 2005-06-30

Mutual fund investors should re-think their attraction to balanced mutual funds, which include both an equity and bond component.

The fee structure for these funds makes them an unnecessarily expensive way to achieve the diversification investors are seeking.

With a little bit of extra effort to manage the bond side of the portfolio themselves, investors can save a fair amount on management fees and thereby produce better returns in their portfolios.

This bit of investment reality seems to be missing in the recent shift of investor money into balanced mutual funds.

Mutual fund statistics for May 2005 show that of the $1.09 billion net sales of mutual funds during the month, the strongest component was balanced funds, at $786 million.

In fact, investors were pulling money out of equity funds, as net redemptions reached $185 million, the 31st month of outflows from that sector in the past 36 months.

The opposite should be happening, with investors instead selling balanced funds and moving part into equity funds and the remainder into direct bond holdings.

To see the point about the fee structure, consider one of Canada’s top-ranked balanced funds, AIM Canadian balanced. According to, it is a five-star fund, with a 14.6-per-cent return to investors in the past year (versus an average 8.6 per cent for all funds in the balanced category), and a 9.2 per cent return over 10 years (versus 7.7 per cent for the average).

The concern is that the management expense ratio (MER) of the fund, at 2.42 per cent, is applied equally to the bond component, which presently accounts for 36 per cent of assets in the fund, as well as the equity component.

Yes, it takes effort to manage a bond portfolio and those doing it need to be compensated. However, historically, bond portfolios don’t do much better than the Scotia Universe Bond Index – certainly it is rare to do as much as 2.42 per cent better.

Also, given that the majority of bond yields are now under 5 per cent, the 2.42-per-cent cut to AIM Trimark comes close to wiping out most of any interest return.

Remember that the high historical returns for bonds in 10 or 15-year comparisons occurred because of capital gains on bonds as interest rates fell. Interest rates are remaining low for the time being, but odds are that inflation will worsen in the coming months and bond yields will be rising, so the capital-gains boost that bond funds, and the bond components of balanced funds, received in the past will not be there in the future to offset the rich MERs being applied.

Investors would be far better off to reallocate 60 per cent of their AIM Canadian Balanced holdings into the AIM Canadian Premier equity fund (MER 2.46 per cent, one year return 21.7 per cent, 10-year return 11.4 per cent), managed by the same portfolio managers who manage the equity component of its balanced counterpart, and 40 per cent into direct bond holdings, or even the Barclays iUnits Canadian Bond Broad Market Index Fund, which is a TSX-traded exchange traded fund (symbol XBB) that mimics the Scotia Capital Universe Bond Index and has an MER of only 0.3 per cent.

A similar re-allocation would be advisable in other fund families. For example, savings are also possible with other high-ranked balance funds, such as the Saxon Balanced Fund (MER 1.87-per-cent, bond component 28-per-cent), or the Dynamic Power Balanced Fund (MER 2.86 per cent, bond component 40 per cent).

To repeat, there is really no need to pay such high MERs on bonds. While diversification is appropriate, balanced funds are for most people, except those just starting out with only one fund, a drag on portfolio returns.

In terms of the motivation of advisors recommending the balanced-fund approach, it is worth noting that they benefit from having the initial commission (5 per cent on deferred sales charge funds) and the ongoing trailer fee, ranging from 0.5 to 1 per cent (incorporated into the MER), apply to the entire amount being invested, rather than just the 60-per-cent equity component.

Advisors don’t earn trailer fees on direct bond holdings or the iUnits – and there probably lies the driving force in why balanced funds are growing so quickly.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2005 Wayne Cheveldayoff