Most financial planning is based on the same basic premise – work for several decades while saving a pot of money, which you will spend once you reach retirement. Indeed, this is the path that the financial industry leads you to – all the while earning fees and commissions by managing your growing portfolio.
I’m asked all the time, “How much of a nest egg is enough to ensure I don’t live in poverty or outlive my money?”
There are lots of calculators online that will help you determine your “number,” but they don’t help you accurately predict the unknown variables – how long you will live and your health, future economic conditions, stock market returns and the rate of inflation. The further away you are from retirement, the harder it is to determine what your desired income will be twenty or thirty years down the road.
The prudent strategy is to work longer to provide a “just in case” buffer, but that’s the opposite of what most people want to do, namely early retirement.
If you want to achieve financial independence, especially earlier than the traditional retirement age, the nest egg has to be quite large. Starting early can take advantage of long-term compounding, but at the same time there are a lot of competing priorities for your employment dollars.
It’s not the nest egg – it’s the income
If you’re worried about being able to save enough from your work earnings to meet your retirement goals, how about supplementing your nest egg be generating regular income streams.
I hesitate to call this “passive” income as it can initially take a substantial time and money commitment and some effort to build. Part of the process is taking the time initially to do some research and understand the risks involved. You want your income creation system to eventually be self-sustaining and need very little of your time to maintain it.
1. Invest in dividend paying stocks.
Investing in high quality, dividend-paying companies can provide a steady income stream, often with regular increases. The upside is it doesn’t take a lot of maintenance. However, you do need a rather large amount of invested capital to create meaningful income.
Starting early and reinvesting dividends can help build a sizeable dividend-stock portfolio over time.
2. Rental property
Renovate your basement to build a rental suite or purchase quality properties with good cash flow. Once the mortgage is paid off the net rental income will help pay your living expenses.
Related: Are you cut out to be a landlord?
Rental property investing takes a bit of time and effort, but, the potential rate of return can be higher than for dividend income. Rental rates often rise over time providing a hedge against inflation.
3. Some other miscellaneous income producers
If you are a creative person, you might be able to produce a product that provides you with royalties – book, e-course, computer software, art and music.
Online income streams come from internet ads and affiliate marketing on websites, or the sale of digital informational products.
Although on the riskier side, you could invest in peer-to-peer lending, be a silent partner in a business you don’t actively participate in, or own a business you don’t operate yourself.
As soon as you can create a stable income stream you can comfortably live on without touching your capital (or be able to stretch out those funds over a longer period of time), you can retire regardless of your age. After retirement, your net worth could potentially increase instead of depleting.
For years I’ve railed against Canada’s mutual fund industry for high fees, conflicts of interest, lack of performance, disclosure, and accountability. But today I’m going to zero-in on the real problem with mutual funds – closet indexing.
Canadian equity mutual funds sold by Canada’s big banks, in particular, are some of the biggest offenders. CIBC Canadian Equity Fund closely resembles the S&P/TSX 60 Index – a fund made up of Canada’s largest companies. The fund doesn’t attempt to differentiate itself from the index, yet it charges a management expense ratio (MER) of 2.38 percent.
The 10-year performance of the S&P/TSX 60 Index isn’t terrific, with annual returns of just 4.9 percent. But CIBC’s Canadian Equity Fund returns have been abysmal at just 1.7 percent per year for the decade.
Is that surprising? It shouldn’t be. A fund that makes no real attempt to differentiate from the index stands no chance of beating its benchmark. Add a grossly expensive 2.38 percent MER and you have a closet indexing laggard.
CIBC’s fund is a bit player in the market, with assets under management of around $244 million. By comparison, TD’s Canadian Equity Fund manages $4.9 billion. It’s a cash cow for TD and its advisors, charging a similarly outrageous 2.17 percent MER. The fund holds 60 large-cap Canadian companies and once again makes no real attempt to stand out from the broader Canadian index.
Canada’s closet indexing problem
“If you deliver index-like returns, you should charge index-fund-like fees.”
That’s what American researchers concluded in 2015 when they revealed that the Canadian mutual fund industry is the world leader in closet indexing. Estimates showed that about 37 percent of the assets in equity mutual funds sold in Canada are in closet index funds.
The key takeaway here is that if your portfolio is made up of mutual funds sold to you by your bank advisor, it’s highly likely that they’re closet index funds. Closet indexing means you’re paying higher fees than necessary while getting less than your fair share of market returns.
Not all mutual funds are bad, however. Index mutual funds, for example, track a broad stock index such as the TSX or S&P. Returns mimic the stock market index, or benchmark, that the fund tracks, minus a small management fee. On the flip side, some mutual funds attempt to beat returns from a broader stock market index by taking a more active role in selecting stocks and timing the market.
Firms such as Mawer have had a successful long-term track record in large part because their holdings differentiate from the index that it’s trying to beat. Mawer’s Canadian Equity Fund has delivered returns of 8.3 percent annually over the last decade, compared to the S&P/TSX Composite Index, which returned 4.7 percent over the same period.
The jury is out as to whether Mawer can continue this outperformance into the future, but the company has two things going in its favour.
For one, Mawer charges relatively small fees for its mutual funds. The Canadian equity fund, which manages $760 million in assets, charges just 1.22 percent MER, which is roughly half of what the closet indexing big bank mutual funds charge.
The second advantage Mawer has over the big banks is that its funds tend to have a high active share, an indicator which measures how much a fund’s portfolio deviates from its benchmark.
A fund with an active share of 0 is identical to the underlying index (i.e. a closet indexer), whereas a fund with an active share of 100 has nothing in common with the index.
In Mawer’s Canadian Equity Fund you’ll find the usual suspects such as RBC and BMO, Telus and Rogers, CP and CN Rail. But the fund is limited to 42 holdings instead of 60-62, and within it you’ll also find smaller firms like Onex Corporation, Automation Tooling Systems, and Richelieu Hardware, to name a few.
These smaller, more concentrated bets help differentiate Mawer’s fund from the big banks’ closet indexing funds.
Canadian investors pay too much and get too little in return. Closet indexing is one of the main reasons why. All of the banks have index mutual funds in their line-up, but your advisor has little incentive to even mention them to you. That’s because it’s “suitable” to sell you a higher fee closet index fund, even though it’s in your best interest to pay less and get better returns.
DIY investors have more options. Index ETFs track the broader stock market and most charge even less than the cheapest index mutual funds. Stock pickers can follow a dividend growth or value strategy to mimic their own Mawer fund, minus the management fee.
The bottom line is that if you discover your portfolio is filled with nothing but closet indexing mutual funds, ask your advisor about a lower cost index fund solution, or switch to a robo-advisor that can manage a low-cost portfolio of index ETFs on the cheap. Finally, if you’re comfortable enough to go it alone, open up a discount brokerage account and find an investing strategy that works for you.