The cost of owning segregated funds has escalated so quickly since the late 1990s that they have become a luxury many investors can't afford.
In fact, they have become so pricey that some well-known fund management firms — including AIM Funds Management Inc. and Franklin Templeton Investments Corp. — have exited the seg fund business because of weak investor demand, a function of a lengthy bear market and a regulatory decision by Ottawa that made them one of the most expensive investment products money can buy.
Seg funds, which are like mutual funds with insurance guarantees, don't draw much attention any more from financial advisers or the press. But they have quietly attracted almost $50-billion in Canadian investors' money, much of that invested during the late years of the bull run that ended with a thump in 2000.
For the insurance companies and mutual fund managers who run them, seg funds represent a lucrative piece of business. But for investors, there's a cost for peace of mind — and in the case of seg funds, it has become so high that they probably aren't worth the money for most middle-class Canadians with fairly simple investment needs.
Most seg funds come with two forms of guarantees. One is a death benefit, so if you die within 10 years of putting your money in, your heirs will get some or all of it back. The other is a maturity guarantee: If you hold your money in the fund for 10 years and the portfolio goes down, you get at least a partial refund.
Seg funds were pretty well the exclusive domain of insurance companies until the late 1990s, when, spurred by the equity boom, mutual fund companies jumped into the seg fund game. Mackenzie Financial Corp., AIC Ltd., CI Fund Management Inc. and others joined the party.
Manulife Financial Corp. added some sex appeal by offering a 100-per-cent guarantee on other firms' popular mutual funds, and invented a new name — guaranteed investment funds — to describe an old idea.
For a while, seg funds were raking in new money. Net sales hit about $6-billion in 2000. That's when regulators started to get a little nervous.
With the markets so volatile and money pouring in, the Office of the Superintendent of Financial Institutions (OSFI) sought some assurance that insurers — which ultimately underwrite the guarantees — could, in fact, afford the seg fund guarantees in the case of a prolonged downturn in equities.
The federal agency, which regulates banks and life insurers, was worried enough by what it found that it imposed new rules on seg funds. In simple terms, insurance companies were forced to earmark capital to cover the guarantees.
That changed the economics of seg funds in a radical way. Costs went up: The average seg fund charged 2.96 per cent in management fees and expenses last year, up from 2.32 per cent in 1998, according to figures compiled by Morningstar Inc.'s Canadian unit. That's a 27-per-cent increase, much greater than the rise in costs for non-segregated mutual funds in the period, and it was too much for some of the biggest players in the fund industry.
“After a while, it began to make less sense for us in our business to be able to operate them because the appeal of seg funds — just because costs went up so quickly — declined for our marketplace,” said Dwayne Dreger, a spokesman for AIM, Canada's fourth-largest mutual fund company. “They just became prohibitively expensive.”
By Morningstar's numbers, seg funds are now about 20 per cent more expensive than the plain-vanilla mutual funds they mimic.
So is the guarantee worth the extra cost? That depends on whether you think stocks will drop over a 10-year period. History suggests the odds are low. Just 36 of the 725 funds in Globefund.com's database with track records of that length lost money in the 10 years that ended May 31, 2004.
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