Is segregated fund security worth the high cost?

[Bylo Selhi]

[New thread started because there was nothing specifically dedicated to seg funds.]

Segregated MMF. Who wudda thunk? Is seg fund security worth the high cost?

Segregated funds are mutual funds wrapped in a life insurance product. They were first introduced in the 1980s primarily for self-employed investors wanting to protect their savings from creditors in the event of bankruptcy -- much like any life insurance product. Segregated funds differ from mutual funds because 75 to 100 per cent of the principal is guaranteed, provided the investor holds the fund for at least 10 years or until death. That guarantee has its price in the form of higher fees. Management expense ratios (MERs) can be as high as 9.8 per cent for a 100-per-cent guarantee and nearly every seg fund has a front- or back-end load. Through the years, seg funds have become increasingly popular with mainstream investors looking for extra security...

When it comes to MERs, the difference between segregated funds and their twin non-segregated fund is often huge. That's where security overkill could come in. Even the most volatile asset classes rarely lose money over a 10-year period. As an example, TD Asset Management Inc. charges investors a 3.2-per-cent premium for the segregated version of the TD Science & Technology Fund. Over the past 10 years the average science and technology fund has lost less than 1 per cent annually, while the Nasdaq 100 composite index has gained 3.5 per cent...

But the worst case of security overkill has to be segregated Canadian money market funds. AIC's segregated and non-segregated versions both hold short-term government treasury bills and low-risk corporate debt, but the segregated version costs investors 0.87 per cent more in management fees annually. While the average Canadian money market fund has returned a mere 2.85 per cent annually, Canadian money market funds have never been known to lose money...

'Most markets won't see a negative return over [a 10-year] time span. So if you're playing the odds, the extra insurance is not necessary.' ---Morningstar Canada analyst Mark Chow

[Shakespeare]

Is seg fund security worth the high cost?

Depends on circumstances. For most, no. For some, yes.

But you should only buy a seg fund [like any other insurance] if it is necessary to protect against a specific risk against which self-insurance is too, er, risky.

[arnyk]

Beat me to it Bylo, read this earlier this morning.

The 10% number really stood out (~9.81%), I mean holy crap I've heard of added value but that's quite a hurdle to get over before you even break even.

Seg MMF, we talked about this before I believe. If there's a 87 bps premium over non-segs, and the regular TD MMF has got 95 bps, then you're pretty darn close to a 2.00% MER. Rate pause by BoC today meaing yields will probably stay close to 3.00%, leaving you 1.00% after fees, 0.60% after taxes? Also, what happens if rates fall? It was only last year that I remember MMF yields running ~2.00%, and it's not like they readily adjust their MERs to compensate. But when rates rise, wouldn't be surprised if the MER was raised accordingly to reward the manager (double digit MERs for double digit yields!).

Agree with Shakes, it should regarded as primarily an insurance product, creditor proofing and such, not an investment.

[adrian2]

Also, what happens if rates fall? It was only last year that I remember MMF yields running ~2.00%, and it's not like they readily adjust their MERs to compensate.

We came pretty close to a threshold a few years ago when I saw several US MM funds yielding 0.1% or less.

But when rates rise, wouldn't be surprised if the MER was raised accordingly to reward the manager (double digit MERs for double digit yields!).

I don't think this is very likely. It will require a unitholder approval (not that it is so hard to obtain).

[Bylo Selhi]

We came pretty close to a threshold a few years ago when I saw several US MM funds yielding 0.1% or less.

As I recall some even reduced their MERs temporarily so as not to suffer the ignominy of going negative.

[arnyk]

We came pretty close to a threshold a few years ago when I saw several US MM funds yielding 0.1% or less.

As I recall some even reduced their MERs temporarily so as not to suffer the ignominy of going negative.

Nice.

[pitz]

http://ul.blows.2y.net/

Geez, I thought the 6% MER of that whole life insurance policy was bad.

Its always amazing what people will buy. Arnyk, think my short of TF.UN will turn profitable soon?

[adrian2]

We came pretty close to a threshold a few years ago when I saw several US MM funds yielding 0.1% or less.

As I recall some even reduced their MERs temporarily so as not to suffer the ignominy of going negative.

How is it possible to go negative, unless they "break the buck"? E.g. they distribute $0.10 (say, as a token return of capital) and let the unit value drop from $10.00 to $9.80 - even then the people who bought pre-distribution would bear the brunt of the full price drop. The other alternative, simpler but equally unacceptable method, would be to distribute nothing but let the unit value slide gradually to $9.90

[NormR]

We came pretty close to a threshold a few years ago when I saw several US MM funds yielding 0.1% or less.

As I recall some even reduced their MERs temporarily so as not to suffer the ignominy of going negative.

How is it possible to go negative, unless they "break the buck"? E.g. they distribute $0.10 (say, as a token return of capital) and let the unit value drop from $10.00 to $9.80 - even then the people who bought pre-distribution would bear the brunt of the full price drop. The other alternative, simpler but equally unacceptable method, would be to distribute nothing but let the unit value slide gradually to $9.90

Reverse split?

[arnyk]

If interest rates ever fell that low, you'd think they'd have at least a modest CG on some of the longer durations (I know it's a MMF so it won't be that long). Use those CGs and distribute a "smaller" payout but the after tax return would be equivlalent to a full interest payout.

[arnyk]

Its always amazing what people will buy. Arnyk, think my short of TF.UN will turn profitable soon?

Last time we talked I said I would wait for the next report to come out before making any moves. It's definately an expensive short given the distributions you gotta cough up each month. By getting in early you're betting that it will tank as soon as Q2 comes out, which means I'll probably be too late if that should happen. I'm too leveraged right now actually to do anything, it's really difficult to maneuver once you're this deep in margin. On a side note, Teranet did an over-alottment thing today priced at $10, which is why I suspect the price is sticking pretty close to that figure through today's trading. Don't underestimate the stubborness of the average trust to continue paying out even when they're running on fumes. Otherwise, I dunno if it's gonna be profitable soon, but I will say that I would not recommend anyone go long on it. That's just me.

[Bylo Selhi]

How is it possible to go negative, unless they "break the buck"?

Exactly. And no MMF wants to do that willingly because that's like a bank that won't let depositors withdraw (all of) their money during a "run." That's why they'd rather quietly cut MERs. ISTR that there were some US MMFs that did break the buck, not in 2003 but in the 1990s, and not because of the Fed rate but because of defaults on the paper they held, however, I couldn't find anything conclusive(*)

Money funds invest in short-term, high-grade IOUs issued by corporations, banks and the U.S. government. They can only pay out what they take in, minus expenses. It's the "minus expenses" part that is causing much of the money funds' discomfort. Consider Munder Cash Investment Fund B, which now yields 0.01%. That's $1 on a $10,000 investment — before taxes...

In theory, there's no reason a fund couldn't subtract its expenses and reduce its share price to less than $1. In reality, "I don't think anyone would do that," says Vanguard founder Jack Bogle. Why? It would break investors' trust in the $2.2 trillion industry, prompting many to take their money elsewhere.

Money funds are priced at $1 per share. If a fund were to fall below $1 per share -- a situation known as breaking the buck -- shareholders could lose money. This could happen if some of the fund's investments blew up. In the past, a few funds have suffered losses that threatened to drive their share prices below $1. But in each case (except possibly one), the fund company reimbursed the fund so it didn't break the buck. A money fund also could break the buck if its investment income fell below its operating expenses. Until recently, this would have been unthinkable...

As of June 17, [2003] there were 209 money market funds yielding 0.25 percent or less, according to IMoneyNet. With the federal funds rate dropping by 0.25 percentage point, all of these funds are in danger of breaking the buck, unless the fund companies reduce their expenses. Some are doing so already. Blessedly, these funds account for only 2.9 percent of total money market fund assets. But if one or more of them broke the buck, it could send shock waves through the industry...

That could be one reason the Fed opted for the smaller interest rate cut. Money funds, with about $2.1 trillion in assets, make up 35 percent of total mutual fund assets. If investors were to lose faith in money market funds, that could drive up borrowing costs for corporations and the U.S. Treasury -- at the same time the Fed is trying to drive them down. "The Fed knows if nobody wants to buy commercial paper, the only way to get people to buy it is to push rates up," says Crane. To stay above a buck, Crane says, money funds will cut costs, and try to renegotiate commissions with brokers...

(*) Added:

Fund companies will go to extraordinary measures to make sure they don't "break the buck"—meaning, let the value of these shares drop below that $1 constant price. For example, in 1994, unusual circumstances involving derivatives and Orange County California declaring bankruptcy caused a few dozen money market funds losses on investments they were holding. In each case, the parent companies of these funds stepped in and absorbed the losses so their shareholders wouldn't have to. To be fair, one institutional money fund did liquidate, causing losses of 6% for its institutional shareholders. But no individual investor has ever lost money in a money market fund.

Did these fund companies absorb the losses out of the goodness of their hearts? Hardly. The truth is, no fund company wants to be known as the first to break the buck. No fund has done it, and if it ever does happen, that company will be marked with a scarlet BB (buck breaker) forever. Little wonder then that these massive financial companies find it more palatable to swallow a one-time loss than live with this perpetual stain on their reputation.

[That last item, coming as it does from a site that "offers biblically based investing advice that is easy to put into practice" failed to mention another option for some investors who are concerned that their MMF might BTB: hope and pray ]

[brucecohen]

How is it possible to go negative, unless they "break the buck"?

Exactly. And no MMF wants to do that willingly because that's like a bank that won't let depositors withdraw (all of) their money during a "run." That's why they'd rather quietly cut MERs. ISTR that there were some US MMFs that did break the buck, not in 2003 but in the 1990s, and not because of the Fed rate but because of defaults on the paper they held, however, I couldn't find anything conclusive(*)

IIRC, a couple of Canadian MMFs did break the ($10) buck on one day in the early '90s. It was due to a very sharp spike in interest rates and only affected investors who redeemed that day. Might have been just one MMF. I don't remember the details, just that it happened. I recall it was in a family that I held. I learned of it only because of a letter the fundco sent out. It was not one of the big bank or big fundco MMFs and thus got no attention.

[Hakim]

I think I recall it being the E&P Money Fund in 1994.

[brucecohen]

I think I recall it being the E&P Money Fund in 1994.

I think you're right. E&P was then independent, before it was bought by Manulife.