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portfolio strategy

Mutual funds are from Venus, and do-it-yourself investors are from Mars.

Or maybe it's the opposite. What we know for sure is that these two parties come together more than you might think at a time when exchange-traded funds are all the rage. A little more than $1 of every $10 in assets held by online brokers is in mutual funds.

Do-it-yourself investing and mutual funds aren't always a great match, though. If they're not careful about which of these funds they buy and where they buy them, they can end up paying for investing advice they do not receive. Online brokers are also called discount brokers, but that's a misrepresentation where some mutual funds are concerned because there's no discount at all on the cost of owning them.

DIY investors mainly hold stocks, and those who don't want to be stock pickers are increasingly turning to ETFs. That's appropriate because ETFs offer low fees, transparency and the practicality that comes from being able to buy as few as three or four such funds to build a sound portfolio.

But mutual funds offer some benefits as well to the self-directed investor:

Experience: Expertise in sectors such as small companies and precious metals, where there are few good indexes on which to build an exchange-traded fund and active management can add value.

Monthly income: There's a vast selection of monthly income mutual funds that hold diversified portfolios of dividend-paying stocks and bonds; ETFs are behind in this area.

Investment programs: No-cost periodic investment programs, where you contribute a set amount of money every payday, every month or every quarter; online brokers are starting to offer their own no-cost alternative, with commission-free ETF trading, but it's not yet widely available.

Access to smart people: The fund company Beutel Goodman is masterly in capturing the Canadian stock market's upside without getting clients massacred in bear markets, while Mawer Investment Management has international investing figured out better than almost everyone else in the Canadian fund industry.

The analysis firm Investor Economics reports that mutual funds account for 11 per cent of assets in online brokerage accounts, or $27-billion. That's down from $33-billion, or 18 per cent of assets, in 2007. ETFs have driven this trend, largely because they're much cheaper to own than mutual funds.

But there's more to the higher cost of mutual funds for DIY investors than you might think. Built into the cost of owning most funds is a "trailing commission" that goes to the adviser and firm selling the fund. Trailers compensate advisers for ongoing client service that should include periodic portfolio reviews and financial planning.

Online brokers also receive trailers from the fund companies, but without earning them through advice. In fact, the concept behind online brokers is to keep costs at a minimum by cutting out advice. Regulators strictly forbid online brokers from advising clients.

Collecting trailers is hugely lucrative for online brokers. If you average out the usual trailers of 0.5 per cent on bond funds and 1 per cent on equity funds to 0.75 per cent and apply them to fund assets at online brokerage firms, you get roughly $200-million annually in revenue.

The actual number would be lower because several of the fund firms most appealing to online investors either dispense with trailers or pare them to a small fraction of the industry average. But there's no getting around the fact that some DIY investors own funds with fees that are larded with trailing commissions.

Who's to blame here? Let's just say it's possible for online brokers to sell trailer-free funds, because at least one firm – Virtual Brokers – does it.

The financial industry uses the term F-class for funds without trailers. F-class funds have trailing commissions stripped out of their fees and can be as much as 1.15 percentage points cheaper to own for equity and balanced funds. F-class funds were designed for fee-based advisory accounts, where advisers charge a fee of 1 to 1.5 per cent of a client's assets. Fund or ETF fees would be on top of the advice fee.

Virtual Brokers CEO Bardya Ziaian said his staff confirmed this week that two big fund companies, CI Investments and Mackenzie Financial, allow Virtual to sell their F-class funds, and he noted that a client had recently purchased an F-class version of a CI fund. "We've never had an issue where somebody has said, you cannot have F-class," Mr. Ziaian said.

In researching my latest online brokerage ranking (read it online), almost all firms said they did not offer F-class funds. Scotia iTrade's predecessor, E*Trade Canada, tried to offer F-class several years ago, but its fund company partner reneged on the deal at the last minute.

Two brokers offer something close to F-class. RBC Direct Investing offers a D-series of RBC mutual funds, with trailers that have been much reduced but not eliminated. Questrade's Fund Maximizer offering rebates of trailers back to clients, less a monthly fee of $29.95.

Questrade CEO Edward Kholodenko said the introduction of Fund Maximizer four years ago helped boost mutual funds from virtually nothing to 5 per cent of client assets. ETFs are more popular today, which explains why Questrade recently made a play for this market by announcing it won't charge commissions to buy any North American-listed ETFs (you still pay to sell). "There's a certain type investor that is interested in mutual funds, but we don't see it growing," Mr. Kholodenko said.

You are not a sucker if you own a mutual fund through an online broker that includes trailing commissions in its fees. But you do have a responsibility to ensure you're getting value for the fees you're paying. Evaluate both short- and long-term returns for their consistency and volatility, and ask yourself whether a less expensive ETF or mutual fund is a better alternative.

Finally, DIY investors interested in funds should consider the handful of companies that include only a small trailer in their fees or none at all. Among them are Beutel Goodman D series; Leith Wheeler; Mawer; a Phillips, Hager & North series; and Steadyhand. You've read the names of these companies in this column before because they're ideal for DIY types who want help with their investing.

For more personal finance coverage, follow me on Twitter (@rcarrick) and Facebook (robcarrickfinance).

Mutual Funds For DIY Investors

Here's a selection of mutual funds you can buy through most online brokers without concern that you're paying excessively high fees.