Four different types of funds, and you’re being asked, all else being equal, which one would you expect to have the highest return over the next 10 to 15 years?
I’m going to work through a practice question from the SeeWhy exam prep tools. In this question, you are provided with four different types of funds, and you’re being asked, all else being equal, which one would you expect to have the highest return over the next 10 to 15 years?
There are three nuggets of knowledge that will help you answer this question correctly. The first nugget is the risk-reward relationship. While there are no guarantees if accepting additional risk, an investor would expect to be rewarded with a higher return. Otherwise, why on earth would she assume the additional risk? For example, if you invested in a relatively safe, short term government guaranteed investment like a treasury bill, you would expect a lesser return than if you assume more risk and invested in a corporate bond or stock.
The second nugget of knowledge is knowing the different risk levels associated with each type of fund. For example, you should know that a money market fund is less risky than an equity fund and will therefore likely generate a lower return. To help remember the basic fund types, you’ll find a great little story and memory aid in the SeeWhy Study guide, and I want to share it with you here as well.
When shopping for a mortgage, I wanted the best interest rate, so I contacted my mortgage broker and guess what he did for me? My mortgage broker brought down every rate substantially. That’s the memory aid. The first letter of each word will help you remember the basic fund types from lowest risk to highest risk. M for money market fund. M for mortgage fund. B for bond fund. B for balanced fund. D for dividend fund. E for equity fund. R for real estate fund and S for specialty funds, such as precious metals funds. Now keep in mind that this is only a generalization, so when dealing with actual clients and investments, make sure you consult the fund’s disclosure documents for the complete picture and to properly assess the risk associated with the investment.
Nugget number three is the additional costs associated with segregated funds. Recall that segregated funds have unique features that mutual funds do not, such as the ability to bypass probate, potential creditor proofing, and even guaranteeing all or a portion of the principal amount invested upon the contract’s maturity date or the annuitant’s death. These guarantees do come at a cost though. All else being equal, a segregated fund would have a higher management expense ratio as compared to an otherwise equivalent mutual fund. For example, if an equity mutual fund generated a pre-MER return of 10% and the MER is 2%, the net return is 8%. On the other hand, if an equity segregated fund generated a pre-MER return of 10%, but had a higher MER of say 3%, the net return would only be 7%.
With these three nuggets in mind, let’s circle back and tackle the question. First, let’s consider risk and reward. If you refer to our memory aid, you will know that an equity fund is generally riskier than a bond fund. Therefore, you would expect a higher return over the long term with the equity fund. This allows us to eliminate both bond fund answers, leaving an equity mutual fund and equity segregated fund as the only possible remaining answers.
Over a long time frame, like 10 to 15 years, we would expect a positive return with both funds. But recall that a segregated fund will typically charge a higher management fee due to the guarantees it offers so all else being equal, due to the relative me, we would expect the segregated fund to have a lower return and the mutual fund to have a higher return. Let’s go ahead and select the equity mutual fund and we’re correct.
After I teach this concept, students often ask me, so then which one is better? A mutual fund or a segregated fund? While the answer is it depends on what’s best for the particular client based on his or her own individual needs and goals. For some clients, the added features that segregated funds provide may warrant paying a higher MER. For other investors, maybe not.
I hope you found this video helpful. Remember, the name of the game is practice, practice, practice, and keep reading those answer keys. You’ll find all kinds of helpful nuggets of knowledge that I promise will turn into gold on exam day.