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Before you leap out of mutual funds by Gordon Pape

A few months ago, I wrote about how many investors have grown disenchanted with mutual funds.
Before I tell you about some other fund options worth considering, let's review why mutual funds became the darlings of investors in the 1990s as we poured hundreds of billions of dollars into them.
• Diversification. You need tens of thousands of dollars to be able to create a properly diversified investment portfolio. Mutual funds provide the solution in one neat package.
• Diversity. It's very difficult for an ordinary Canadian to invest in overseas securities. With mutual funds, it's a snap.

• Cost. Many of these funds are offered on a no-load basis, notably those from the banks and companies such as Altamira, which pioneered telephone sales.
With discount brokers still minor players, it beats paying hefty commissions incurred by buying stocks.
• Accessibility. You can buy into most mutual funds for an initial investment of $1,000 or less. For RRSPs, the entry price is even lower.
All these advantages remain. However, the bad taste left by the bear market of 2000-2002 has prompted many people to move on. Here are some options.

Exchange-traded funds (ETFs)This term is generally applied to index-linked securities that trade on stock exchanges.
Their performance tracks an underlying index. Some are tied to major indexes, such as the S&P 500, but most are more specialized, tracking sub-indexes such as energy, gold and income trusts. Some U.S.-traded ETFs track specific country indexes, including small nations such as Austria.

Pros: Low management expense ratios (MERs); variety of choices; returns closely track target index.

Cons: Brokerage commission charged; specialized ETFs can be highly volatile, vulnerable in falling markets.

Closed-end fundsUnlike ETFs, these portfolios are actively managed in the same way as most mutual funds. In Canada, most closed-end funds invest in common stocks or income trusts; however, a few are more specialized. For example, Northwater Market-Neutral Trust (TSX:NMN.UN) holds a portfolio of hedge funds. Some closed-end funds in the U.S. specialize in countries that are otherwise hard to invest in, such as Korea, India, and China.

Pros: Active management provides more flexibility; MERs usually below those of comparable mutual funds; broad diversity of choices.Cons: Brokerage commissions payable; higher MERs than ETFs; volatility in specialized funds.

Index-linked GICsPopular among investors who want some stock market exposure but worry about a repeat of the bear market, these are issued by banks, which guarantee the principal at maturity. However, unlike ordinary GICs, interest is not guaranteed but is based on the performance of the underlying index over the term of the GIC. That means you could tie up your money for three or five years and get nothing back but your original investment at the end of the day.

Pros: Protection of capital; no commissions payable.Cons: Possibility of zero return; some have a cap on the maximum payout.

Bond ladders: As an alternative to bond mutual funds, some people have set up bond ladders through their brokers. This is simply a bond portfolio with staggered maturity dates, often one or two years. In this way, some of the bonds mature periodically, allowing for reinvestment, and the investor benefits by averaging up the interest rates (longer-term bonds usually pay a higher rate than those that mature in a year or two).

Pros: No ongoing MERs; easy to understand; relatively low risk, especially if government bonds are used.Cons: Commission payable on bond purchases (usually hidden); lacks diversification of bond fund portfolio; no active management
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So if you've soured on mutual funds, there are other choices. But remember there is no such thing as a perfect investment.

Gordon Pape, Contributing Editor of 50Plus.com, is one of Canada's best known and most respected financial authors and commentators. He is Publisher and Editor of the popular Mutual Funds Update and Internet Wealth Builder newsletters.
© February 2005 50Plus Magazine