Segregated Funds
Posted by Gail | Filed under Investing
Tuesdays have turned into Special Notes Day.
So, keeping with the trend, check out the special notes at the end of this blog.
Yet another variation on the mutual fund is the segregated mutual fund, or seg fund for short. For all those investors determined to have their cake and eat it too, the problem with expecting too much is that you might be left with a bad taste in your mouth. The cake in question: your capital. The mix: buy a segregated mutual fund, keep your principal safe, earn a great return in the equity markets. The problem: that guarantee ain’t all it’s cracked up to be.
Segregated mutual funds have been sold without much fanfare by insurance companies since the early 1960s. They look like mutual funds and taste like mutual funds. But the icing on the seg fund cake is the principal guarantee — a promise that you’ll get back between 75 and 100 percent of your capital after ten years, even if the market is in the garbage can. The guarantee also becomes effective if you die before the ten years are up, so your heirs won’t be left holding a plate of crumbs.
This guarantee comes with a price: since it is created through having the capital invested insured, seg funds are served up with a higher MER than are similar mutual funds without the guarantee. To sweeten the mix even more for investors, seg funds often come with the option of locking in a rise in the value of your funds. So if you bought a seg fund today, and three years from now the market was up 12 percent, you could lock in the increase. The downside: you’d also be resetting your guarantee timer for another ten years. So if you need your money between now and then, you’ll be out of luck in terms of the guarantee. That lack of liquidity can be a real downer for some.
If you’re determined to protect your capital, but you want to partake of the feast currently being served up in equity markets around the world, here’s an idea. Invest your capital in a monthly pay GIC. While you may earn up to .25 percent less in interest than with a regular GIC, your principal will be guaranteed. Then, each month, take the interest you’re earning and dollar-cost-average into an aggressive, growth-oriented mutual fund. Your principal will be safe, and over the long-term you’ll be able to participate in growth in equities to increase the overall return on your investment.
Another alternative would be to invest in a combination of strip bonds and equity investments. Since a strip bond is bought at a discount and guaranteed to mature at a specific amount, you could buy one that matured at the full value of your original capital. If you were investing $20,000, for example, you’d buy a strip that would mature at $20,000 in ten years. You’d then invest the difference in individual stocks or indices — wherever you think you’d get the biggest rise.
Seg funds do have their moments. They’re a good investment if you’re looking for creditor protection because you’re self-employed or a small-biz owner. Since segs are an insurance product, they can be protected from creditors if you are forced into bankruptcy. Segs also offer unprecedented estate protection. Like other insurance products, money in segregated funds pass directly to heirs named directly as beneficiaries without going through your estate, which means no estate fees or death taxes (where applicable). And since some seg funds pro-rate their income distribution based on time in the fund, the problem of buying into someone else’s potential capital gain is solved.
Next Week: What to Consider Before You Buy
Last Week: Closed-End Funds
—–
Farah wrote to me to say: Like Fiza, I am a muslim looking into the world of shariah compliant investing. The best person to talk to is Jeff (Jaafer) Gareau of No Interest Investments Hope that this helps all muslims out there!
And I got this note from John Sullivan: We created a free web app for people to track their spending. It is very simple to use, can be shared with other family members and includes simple budgeting as well. It will always be a free app. If you think your readers might be interested the url is http://yourdough.com.
June 15, 2010 at 7:59 am
I like the alternatives for the seg funds. I think I need to look into a bit of capital protection for my investments.
regards,
Jason
June 15, 2010 at 9:09 am
Great post Gail!
Another alternative to help those people that want the investment guarantee but do not like the risk or high fees associated with a segregated fund is a Market Linked GIC. These GIC’s can be linked to the performance of the stock market (TSX, Nikkei, etc) or can be linked to the performance of a mutual fund (i.e. RBC Market Access GIC’s), the benefit is that you have the ability to partially participate in the performance of the stock market (i.e. stock market up 10%, you’re participation rate may be 60%, so you’re actually going to be up 6%) all with guaranteed principle.
With everyting there is risk and with a Market Linked you may be in a postion where your money is locked in for 3 to 5 years and the markets have not experienced any growth. You can also have a low participation rate, thus not allowing you to participate in the full growth that the market experienced.
Regardless, lots of choices when it comes to guarantee investing with little to no risk.
June 15, 2010 at 9:39 am
@ Tyrone – Market linked GICs are generally regarded as mediocre investments.
I think a big reason, in addition to the participation factor cutting into your return, is that the fine print on these GICs: “Investing in this type of GIC is not the same as investing directly in the stocks of the S&P/TSX 60 Index. For example, you won’t have the right to receive any dividends or distributions. The return on your GIC will not be identical to
the return associated with the index.” (See “Before you Invest” on the RBC fact sheet: http://www.rbcroyalbank.com/business/services/pdf/FS&SC_Canadian_Market-Linked_GICs_Final_E.pdf )
In other words, you don’t get the 2-5% dividend return that many stocks return. That’s a huge difference between a regular index fund and these GICs.
June 15, 2010 at 10:34 am
This is a bit off topic but reading this investing post made me think again about a question I have been unable to find the answer to. If you have any information on this Gail (or anyone else) I’d appreciate it.
I’d like to invest in a small way in ethical funds. Ideally I’d like to find a company/organisation that has something already set up (as I’m not well versed in investing) – for instance something like the couch potato fund that Moneywise put forward as a good investing strategy BUT focused on ethical funds. I know ING have an investing account that works like the couch potato but it’s not (as far as I’m aware) focused solely on ethical funds … but if there is anything out there like that I would love to hear about it.
I also know that the whole definition of “ethical” can vary and that you need to really look at the criteria for selection – but I’m struggling even to find anything like this in Canada. In England this is quite common but when I first came over here 8 years ago, the TD person I spoke to about my RRSP looked at me as if I had 2 heads when I mentioned ethical funds … they’d never heard of the concept (BTW I live in Ontario).
I also know that one doesn’t make a lot of money investing in ethical funds compared to other types of funds – but I’m not so bothered about that. It’s more the ethical thing that bothers me – with the situation with BP and the oil well it’s become even more important to me that whatever I invest in reflects my values in life.
Any info appreciated. Thx.
June 15, 2010 at 11:30 am
@Geoff Yes, you don’t get as big returns on the index GIC’s but the principle is 100% guaranteed, which isn’t the case with a regular index fund.
Sadly there is *always* a trade off to keep principle 100% secure. It still has the potential to perform better than a traditional GIC.
@Angela I may be *exceedingly* cynical, but I think anytime a large group of people get together with the idea of making money, ethics will always be secondary, regardless of their published goals.
I would either a) investigate companies and find one that meets your standards of ethics and invest in individual companies or b) invest without regard to specific restrictive ethics (except for obvious ones) and donate a percentage of the profits to specific ethical charities directly.
I researched alot on the some of the supposed ethical funds awhile ago, and was disappointed with the results. To some, ethical is a marketing phrase not a moral compass.
June 15, 2010 at 11:33 am
Thank you for the special note at the end. While exploring the link you sent I found a great tool that lets me see how much faster I can pay off a loan with extra payments. It’s a very handy, very user friendly app and I know if YOU recommended it, it must be worthy indeed.
As always, Gail, you brighten my day and teach me new things. Thank you.
June 15, 2010 at 12:20 pm
@ Kat – that loss of dividend payments is huge and can’t be sluffed away. You can build your own principle-protected note (which a market linked gic is) on your own and invest it to get dividends yourself. http://michaeljamesmoney.blogspot.com/2009/01/analyzing-market-linked-gics.html has details.
I don’t think it’s even a bad thing that you can’t achieve high returns without equivalent risk. In fact, our capitalist society is based on that very idea – from Ford to Gates to those google boys, they all took a chance on a business they started and it could have gone either way. I think people should spend more time deciding what’s important – risk or return – and choose the best products in those. These best of both worlds products are terrible choices usually resulting in the worst of both.
June 15, 2010 at 12:36 pm
Hit enter too quickly and forgot other reason why PPNs aren’t very good.
With a PPN, “a large chunk of your invested money goes to purchase a stripped bond or derivative that provides the return of capital guarantee at maturity. So only a fraction of the invested amount actually works for you.”
In other words, the bank takes your money and invests it to make sure it won’t have that guarantee come back and bite itself in the butt, and just invests whatever’s left over – and then takes a slice of that return too! Good for the bank, not for you.
http://www.globefund.com/servlet/story/WISE_INVESTOR.20071009.weekly/GFWIStory/
June 15, 2010 at 1:17 pm
@Geoff I was sluffing? I don’t know what that is – but I like that word!
I think we’ll have to agree to disagree that the “best of both worlds” products are terrible choices resulting in the worst of both – especially with traditional GIC rates so low.
But you are in fact preaching to the choir, risk and I are best friends. Over 50% of my portfolio is in one company today. I’ve done it before, and I’ll probably do it again. And although it is traditionally a good company with low risk, everyone thought that about Enron.
I was merely pointing out that they those GIC’s have 100% principle guaranteed which the other items you pointed out did not.
And I agree with good for the bank, they’re very greedy. Which is why a majority of my holdings are usually in Cdn banks – they have a stranglehold on the population, give dividends and are unlikely to have problems — just look at how well they weathered the debt crisis.
June 15, 2010 at 1:59 pm
@ Kat – fair enough. But I’m thinking more about the people who invest in these things blindly thinking they’re getting a good deal, when probably for about 90% of them they’re getting hosed hard.
June 15, 2010 at 2:31 pm
Angela:
I think that I was told that Credit Unions are more likely to offer ethical funds.
BEFORE you get into that… read “confessions of an unethical investor” which should be somewhere on the Money Sense website.
The main message: you change the world with what you consume and not what your investments are.
Kat:
If you search the archives, Geoff and I had an exchange about this a while back. (Note that TD changed their # since that exchange.) Geoff: you missed out on another possible big negative! If you hold a Market Index GIC, you must pay tax on 100% of the profits (not so for capital gains). Therefore I hold mine in TFSA and RSP.
June 15, 2010 at 3:10 pm
@ Geoff – the point I was trying to get across was that GIC focused individuals have the opportunity to participate in the market and still guarantee their principle without having to pay the high fees associated with a segregated fund.
Different investments for different people. One point I want to stress is that a product has both features and benefits. The features will not change regardless of who holds the product, however, the benefit will differ for each person as its something that is unique tothat individual.
GIC has many features, but one benefit that it provides to many people is peace of mind, something that can’t be ignored regardless of the pros, cons and statistics that anyone can present.
June 15, 2010 at 3:42 pm
@ Marie — great point about the taxable part of the GIC – read the article, thanks for the mention of it.
June 15, 2010 at 3:59 pm
@ Tyrone – agreed but this was specific to market-linked GICs, not GICs in general. GICs do have a place in some people’s investment strategy IMHO but these do not for the majority of people. And some of these PPNs charge MERs on top of everything else.
I have no problem with anyone purchasing these or any financial product really (of course it’s not my business) but I just don’t like the way they’re sometimes marketed. Like for instance how regular ‘GICs are no risk!’ but they conveniently forget that inflation eating your returns is a real risk and not a hypothetical issue.
@ Marie – good point.
June 16, 2010 at 12:57 am
Re: Ethical funds. Fair point Geoff – There’s perhaps a strong argument that the ‘ethical’ thing for us all to do would be to drive a little less (lot less?) and consider expending the funds for an electric or battery powered vehicle.
Lots of aspects to consider when we think about how we spend our $$
June 17, 2010 at 5:01 am
nice post, you deserve a free iPad: http://bit.ly/freeipad6
June 22, 2010 at 6:21 am
[...] Last week: Segregated Mutual Funds [...]
October 26, 2011 at 3:29 pm
Iphone pas cher…
Respect to article author , some great selective information ….