Let’s start with cash. Today, the net return on a money market fund is practically nil. If you deposit your savings in a one-year GIC, you’ll be lucky to get 1.25%. With inflation running at about 3% so far this year, you are losing close to 2% in purchasing power each year. That’s a high price to pay for safety.

What about government bonds? The benchmark 10-year Government of Canada bond yield as of early November was 2.15%. Again, with inflation at about 3%, your net annual purchasing power loss is almost a full percentage point. And that doesn’t include fund fees.

These low yields might be a fair price if they came with peace of mind. They don’t. The important thing to remember with bonds is that your long-term return is mostly determined by the prevailing yield at the time of buying. Yes, you may have temporary capital gains if yields decline, or capital losses if they rise. However, those gains or losses disappear as you approach maturity. The major risk with bonds today is that if inflation stays high or rises further, you will be stuck with negative real returns.

There is one investment that gives you the best of both worlds: safety and inflation protection. It’s called a real-return bond (RRB), or inflation-protected bond.

Before I elaborate, let me explain how RRBs work. Traditional bonds have a “coupon,” which is the annual interest rate you receive on the principal. If the bond’s principal is $100 and the coupon is 1%, you’ll receive $1 in interest every year. (More properly, you’ll receive 0.5%, or 50 cents, every six months.) When the bond matures, you get your $100 returned to you.

With RRBs, the coupon always stays the same, but the principal gets adjusted every six months based on the rate of inflation, as measured by the Consumer Price Index. For example, if you invest $100 in an RRB and inflation is 2% during the period, the principal grows to $102. Your semiannual interest payment is based on that adjusted amount: you’d receive a payment of 0.5% of $102, or 51 cents. That goes on until the bond matures, at which point you receive the inflation-adjusted principal.

To me, RRBs are a plausible alternative for investors who want the safety of bonds combined with inflation protection. Unfortunately, there’s no such thing as a free lunch. Today, the average yield on Canadian RRBs is 0.85% or so, excluding the inflation adjustment. In other words, 0.85% is your expected real return after inflation, but before management fees. Problem is, the cheapest RRB fund in Canada carries a 0.29% annual fee. So after paying fees, your real return on a bond held to maturity in this fund can’t exceed a paltry 0.56% per year.

That’s not all. The shortest RRB maturity available in today’s market is 10 years, and the average term to maturity of your typical fund is 20 years. Thus, by investing in one you will have condemned part of your portfolio to mediocrity for 20 years or so.

For those reasons, most analysts and advisors have stopped recommending RRBs to their clients. Their argument is simple. Not only is the return mediocre, but the risk, in their view, is high. Over the past 10 years or so, the yield on RRBs has gradually dropped from 4% to 0.85%. If yields revert back to the historical mean, capital losses could be significant. By significant, I mean that each 1% increase in RRB yields would reduce your fund’s market value by 16%.

Okay, that’s the downside. Stay with me though, because there’s an upside too. I personally am willing to live with the risk inherent in RBBs for several reasons.

First, an inflation-safe bond with mediocre returns is better than one exposed to inflation risk. Every investor needs some bonds in his or her portfolio, and I’d rather have the former.

Second, RRBs have an inherent stability mechanism and are therefore not as risky as people fear. The probability of RRB yields rising again is very low in the foreseeable future. Remember that bond yields rise for two reasons: when inflation expectations rise, or when the credit risk of the issuer worsens. With RRBs, the inflation adjustment takes care of the former. As for credit risk, RRBs are primarily issued by the federal (and to a much lesser extent, provincial) governments, all with good credit standing.

Third, bond yields are subject to the laws of supply and demand. Here is the key point: RRB supply is scarce, and when supply is short of demand, prices remain high (and yields remain low). Currently, RRBs represent no more than 5% of the total supply of government bonds. The Canadian government projects this to increase to 10%, but I still believe supply will remain tight.

The fact is, governments have a disincentive to issue RRBs unless they believe future inflation will stay very low. And barring a European-induced financial meltdown, global inflation is here to stay. While they won’t admit it, governments like this combination of low interest rates and moderate inflation because it lightens their debt burden significantly. If you’re paying 2% interest on your bonds and inflation is 3%, your real cost of borrowing cost is negative. If governments can borrow today at negative cost, why would they issue RRBs that close that gap and make borrowing more expensive?

With all of this in mind, putting some of your portfolio in an RRB fund is not a bad idea. But don’t go for the kill. The risk of higher yields—and therefore falling prices—cannot be completely ruled out. More importantly, don’t put in any money that you may need in the next five years. RRBs have very long maturities, and rising interest rates may force you to sell the bonds at a loss.

How much should one invest in RRBs versus regular bonds? Before you decide, understand that RRBs have a built-in inflation expectation. As I mentioned earlier, RRBs yield about 0.85% today, while regular government bonds with comparable maturities yield roughly 2.9%. The difference between those two yields (just over 2%) is what the market expects inflation to be. How much you allocate to RRBs and regular bonds depends on whether you agree with the market. If you expect inflation to be more than 2%, add more RRBs. If you expect inflation will be lower than that, you may want to favour traditional bonds. A balanced approach would include equal amounts of each.

Note that RRBs are not suitable for retired investors who rely on capital withdrawals to supplement their income. The income RRBs spin off is not that rich to start with, because the inflation adjustment is added to the principal, not paid out in cash. RRBs are most suitable for middle-aged investors who are saving for retirement and want to ensure their fixed-income investments keep pace with long-term inflation.

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The “Keeping it real” chart lists RRB funds available to Canadian investors. As you can see, most of them are way too expensive. To begin with, there is no value added from active management, because all the fund managers have only a handful of bond issues to choose from. Therefore, the underlying portfolios in these funds are nearly identical. The best choice, therefore, is one of the less expensive exchange-traded funds, such as the BMO or iShares offering.

Both ETFs have very similar portfolios, with an average maturity of 20 years or so. The BMO ETF is entirely composed of federal government bonds, whereas the iShares ETF has a small component of provincial bonds with a slightly higher yield. I expect the two funds to deliver very similar returns over the long term. For the first half of 2011, both have reported a nominal annual income of 2%, made up of coupon payments with the inflation adjustment. I expect that to improve slightly to 2.5% or so in the second half due to higher inflation.

You’ll notice that the total returns on real-return bonds (that is, interest payments plus price increases) have been extremely good in recent years. But please do not be fooled. This is history that is not likely to repeat itself any time soon. As RRB yields kept dropping, bond prices climbed up. But yields have now reached very low levels and have limited room to drop further, unless people decide to start lending to the government for free. Therefore, the potential for any capital gains is much lower. You do not buy an RRB fund in order to make big bucks, but rather to protect your wealth from inflation while earning a small income.

First, emerging economies will continue to grow rapidly compared to developed economies. In fact, with developed countries on the verge of another economic slowdown—possibly even another recession—emerging markets are the only place where you can expect to see any significant growth.

Second, most emerging countries are no longer plagued with debt problems. Their international trade balances have massive surpluses and their central banks are flush with foreign reserves. Unlike in Europe, North America and Japan, where governments are burdened with budget deficits, the governments of leading emerging countries have put their fiscal houses perfectly in order.

Third, valuations are now attractive, relative to the rest of the world. The average forward price-to-earnings (P/E) ratio of emerging market equities is currently in the range of 12 to 13, compared with 14 to 15 for global equities. In China, Brazil and South Korea, for example, stocks are currently trading at forward P/E ratios of 10 or less (a forward P/E ratio expresses the company’s stock price as a multiple of its expected earnings for the next year).

Fourth, dividend yields are attractive. Unlike the old days when you bought emerging markets purely for rapid growth, you can now count on growth and decent dividend income. This is good, because dividends represent an objective measure of a company’s financial health. Stated earnings can be manipulated (particularly in some emerging countries; I won’t name names), but dividends are real cash in your hands. Companies that pay high dividends have less room to engage in accounting games.

Fifth, the banks in the emerging countries are the least exposed to Europe. A healthy banking system is critical for economic growth. With all that’s happening now in the Eurozone, the impending crisis is bound to affect banks exposed to European debt. In this respect, the Asian and Latin American banks, which represent the highest component of emerging market indexes, will be less affected than American and European banks.

Finally, the emerging currencies are strong. This is both good and bad: currency appreciation has the potential to offset some of your losses and add to your gains when markets rebound. However, currency strength is also related to inflation and high interest rates, which are not good for stocks, and this largely explains the recent 25% dip in the markets.

Indeed, inflation is the major risk currently surrounding emerging market equities. Some economies, such as those in Brazil, China and India, are now truly overheating, with inflation rates in the 6% to 8% range. As a result, interest rates are becoming dangerously high. In Brazil, for example, short-term rates are currently north of 10%.

It is all but certain that high interest rates will quell economic growth eventually. The objective of governments and central banks is to manage a soft landing where economies cool down enough to control inflation, but not so much that they induce a recession. The danger is that if they press too hard on the brakes, economic growth will come to a grinding halt.

Moreover, emerging economies are not isolated islands: many depend heavily on exports to the West and Japan. That means a major slowdown in global economic growth will result in reduced demand for their exports. There are already signs that this is starting to happen, as China’s fourth-quarter growth is now forecasted to slow to (a still whopping) 8.5% from nearly 10%.

There is also the nagging issue of governance and transparency. In many emerging countries, the law is still applied selectively. Corporate governance and accounting standards are not as strict as in developed markets, and therefore financial statements and earnings reports are not always reliable. This problem occasionally spills over to companies listed on western stock exchanges, as we recently saw with the Sino-Forest case. Moreover, despite their relentless economic growth, countries such as China and Russia still have major structural economic problems that remain to be resolved.

If economic concerns materialize into a full-blown recession, we may see further market weakening. You will also feel the heat of currency volatility, as exchange rates will strongly (but temporarily, I believe) favour the U.S. dollar as a safe haven during periods of market turmoil. But as I said, investing is not about market timing. It’s about buying low and selling high, which means you add to your positions when the news is bad and prices are down.

So what is the best way to invest in emerging markets? Certainly picking individual stocks is out of the question for most investors, so mutual funds are the most sensible choice. “The passive route” table provides a list of exchange-traded funds (ETFs) with low management expense ratios. The Vanguard MSCI Emerging Markets ETF (NYSE:VWO), for example, charges just 0.22%.

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The beauty of ETFs is that they give you exposure to hundreds of individual stocks in many emerging countries. They are fully invested at all times, so you will fully benefit from a market rebound when that happens. On the flip side, however, you will take the full brunt of any further downturn.

The two WisdomTree ETFs offer an interesting approach. Unlike most emerging markets indexes, which are dominated by large-cap companies, the WisdomTree indexes focus on dividends and have whopping yields in the 6% to 7% range. Both funds have a high allocation to Taiwan and little exposure to China, India and Russia. Exposure to banks is high, which is typical of dividend funds. This means the waters will be choppy in the short term, particularly if we have a full-blown credit crisis. However, dividend yields will provide good support in the long term.

The other table provides a list of actively managed funds for you to consider. The major problem with these funds is their high cost. The moment you steer away from index funds, your annual management fees jump by a lumpy two percentage points or more. In most cases, these costs are more than enough to offset the fund’s dividend income. Still, this is a category where risk is high, so the comfort of having a skilled manager is, for many investors, worth the cost.

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AGF Emerging Markets has been a good performer. For the past three years, the fund has beaten its benchmark, and its average annual return over the last five years is almost 10%. It follows a bottom-up approach: in other words, the manager’s strategy is based on individual stocks rather than sectors or countries. Against that backdrop, no single sector or country represents more than 15% of the total portfolio. My major concern with this fund is the very high management expense ratio (MER), which is more than 3%. That said, one must recognize that the extremely low portfolio turnover (10% to 15%) partly compensates for that.

Brandes Emerging Markets Equity also has one of the best long-term records, with an 8.8% average five-year return. It has recently been hurt by its exposure to financials and some other individual holdings in the consumer sector. However, on balance, the fund presents some advantages in the form of broad diversification across sectors. This can help smooth out the ride in this highly volatile space. Again, the low turnover compensates for the high MER.

If you truly believe in buying low and selling high, you need to tolerate short-term volatility. That’s why investing in bad times takes so much courage and discipline.

You don’t need to do a lot of research to conclude that if two funds invest in similar securities, the one that charges less will deliver better results. Some will argue that funds that have delivered good performance deserve higher fees, but let the numbers speak for themselves. In the table “Costs matter” I have sorted funds from four major investing categories—Canada’s cheapest Canadian fixed-income mutual funds, Canada’s cheapest Canadian neutral balanced mutual funds, Canada’s cheapest international equity funds, Canada’s cheapest Canadian equity funds—into management expense ratio (MER) quartiles. (The MER is the total annual fee you pay for each fund.)

The first quartile contains the cheapest 25% of funds and the fourth quartile contains the most expensive. For each quartile, I calculated the average five-year return to see how the MER affects returns. (Since I’m assessing whether manager performance justifies higher fees, I’ve excluded index funds. To compare apples to apples, I’ve also left out institutional funds, U.S. dollar series, and Series F funds.)

The table provides compelling evidence that management expenses have a direct, negative impact on long-term returns: the cheapest quartiles have the highest returns, and vice-versa.

Why is a fund manager’s ability to add value so limited? In the case of fixed-income funds, there is simply a limited supply of investment-grade bonds, so most managers end up in the same issues. Some may use tactics such as buying longer maturities when they believe interest rates will go down, or keeping their bonds shorter when they expect rates to rise. Sometimes they get it right, sometimes they don’t. Over the long term, bond funds tend to perform quite similarly to their indexes, less management expenses, so keeping fees low is essential. The same applies to balanced funds, which usually include 35% to 40% bonds.

What about equity funds? Since there are so many more investment choices, you would expect your fund manager to earn his or her fees by picking stocks that will outperform the market. In reality, it’s not that simple. Managers do not have free rein: they have to invest in a prescribed set of assets, as determined in the fund’s objectives. They also have other limitations that prevent them from concentrating too heavily in any particular company or sector.

Even if they are permitted to make concentrated bets, most managers are reluctant to do so, because they have too much to lose if they get it wrong. When things don’t work out, both investors and the fund’s sponsor will blame the manager: money will flow out of the fund and the manager may lose his or her job. But if the fund cuddles up to the index, the manager can always blame the market if performance is poor. As a result, many fund managers end up sticking closely to the securities in their benchmark.

Even fund managers who outperform do so for a limited period of time. They may enjoy success as the result of a good call on some individual securities or sectors. More often than not, unfortunately, their success is short-lived. Markets are largely efficient and very difficult to outguess consistently.

All of which brings us back to cost. If a fund manager’s ability to add value is so limited, charging higher fees is hardly justified. Look at the tables on the opposite page, which list the cheapest funds in each of four categories: Canadian fixed income, Canadian neutral balanced, international equity and Canadian equity. As you can see, the vast majority of these funds report above-average returns. My intention here is not to endorse any specific fund (although a low MER is a good starting point), but rather to prove that paying higher fees to your manager will not necessarily reward you with higher returns.

Armed with this evidence, should you just go and buy the cheapest funds to maximize your returns? Not so fast. First, you need to select the funds that suit you best in terms of your financial objectives and risk tolerance. After excluding consistently poor performers, determine if you like the fund’s investment style (value or growth) and portfolio composition. After you’ve whittled down your choices to a short list of suitable funds, then you can select the cheaper ones.

You also need to look at the big picture. Management expenses are not the only cost component. You need to factor in commissions, such as front-end loads or deferred sales charges. Trading costs can also cut into returns, and these are directly related to portfolio turnover. Brokers always take their cut when fund managers buy and sell securities, so the higher the turnover, the greater the fund’s costs. And if you’re investing outside an RRSP, you’ll pay capital gains taxes on any trade that turns a profit.

Imagine what impact this can have if your fund manager buys and sells too often: A fund with 200% portfolio turnover and a 2% MER may be more expensive than a fund with 30% turnover and 2.5% MER.

An excellent resource is the fund’s semi-annual Management Report of Fund Performance, which details all costs as well as portfolio turnover. (You can find this document at www.sedar.com.)

Finally, don’t forget the price of advice. Your fund MER includes two major components: management fees paid to the portfolio manager and trailer fees (usually 0.5% to 1%) paid to the adviser or broker who sells you the fund.

If you do not need investment advice, you can reduce your costs by buying funds that do not charge trailer fees. Some fund companies (including Mawer, Phillips Hager & North, Steadyhand and RBC) sell funds directly to do-it-yourself investors, with no advice fee built in. (These are often called “D Series” funds.) However, to open an account you will typically need a starting investment of $10,000 or more, depending on the company. Another option is to buy no-load, no-trailer funds from a discount brokerage, which will often require a lower minimum investment.

If you need investment advice, your overall cost will be higher. Still, one option is to buy “F series” funds, which have much lower MERs because they do not pay trailer fees. F Series funds are sold by advisers who then add their own fee separately. Usually these advisers charge a minimum annual fee of at least $1,000, however, so this option is suitable for investors with large accounts. For example, if you have only $10,000 to invest and your adviser charges a fee of $1,000 per year, that represents 10% of your total investment, which makes “F series” funds uneconomical.

For investors who need advice but have smaller amounts to invest, there may be no other choice but to go with the more expensive funds. If this is your only option, make sure that your fund’s MER does not exceed 2.5% (1.5% for fixed income). If you’re happy with the quality of service and advice that you get from your adviser, the embedded trailer fee will be well deserved.

But when it comes to investing, the possibilities are vast once your portfolio grows beyond $100,000. Problem is, much like Bertie Bott’s Every Flavour Beans (a devilish Harry Potter confection) the investing flavour you choose might wind up tasting like earwax. Alas!

That’s why the advice in Where to invest $10,000 still applies. If you aren’t intensely interested in the markets, you should probably stick with a good low-fee balanced mutual fund. After all, much like grilling a nice steak, if you poke and prod your portfolio too much then you’re likely to obtain less than desirable results.

But if vanilla really isn’t for you, let’s check out some other tasty ways to invest now that you have a more sizeable portfolio.

The lazy way to riches
In the “Where to invest $1,000” story, we introduced the idea of investing using passive index mutual funds such as the TD e-Series Funds, which rise and fall in tandem with the large market indexes. Long-time MoneySense readers will know that we call a portfolio of such funds a “Couch Potato portfolio,” as it’s so easy to execute, you rarely have to haul yourself up from the couch to tend to your investments. The goal is to take the returns the markets give you while keeping your investing costs as low as possible. This allows you to enjoy a big advantage versus high-priced fund managers who, far too often, fail to earn back the fees they charge investors.

Now that your portfolio is larger, we have some good news. You can implement the exact same strategy with a new type of fund that has even lower costs: the exchange-traded fund or ETF. These funds are much like index mutual funds in that they passively follow a market index such as the S&P 500, but instead of being sold like mutual funds, you buy them on the markets, just like a stock. The ETFs you choose depend on your investment goals, your time horizon and your tolerance for risk, but we find that plonking 40% of your money into a good bond fund, and spreading the remaining 60% among Canadian and U.S. stock funds is the simplest way to start. If you do it through ETFs, you can reduce your fees to very low levels. For example, if you use the iShares S&P/TSX60 ETF (XIU), the Vanguard Total Stock Market ETF (VTI), and the iShares DEX Universe Bond ETF (XBB) for the Canadian stock, U.S. stock, and Canadian bond components respectively, then the annual fee on your portfolio will be a minuscule 0.19% a year.

Just remember, because ETFs are traded like stocks, you do get dinged with a brokerage commission when you buy and sell them. The commissions can really add up for small portfolios but, by $100,000, the big Canadian discount brokers usually offer online trades for $9.95 a pop, or less.

Much of the appeal of Couch Potato investing lies in its simplicity, so you don’t want too many funds. Still, if you’re up for it, expanding beyond just U.S. and Canadian stocks is a sensible thing to do. As a result, I suggest the Global Couch Potato variant with international stocks added via the Vanguard FTSE All-World ex-US ETF (VEU). Here you’d put 40% of your portfolio in the XBB bond ETF, 20% in Canadian stocks via XIU, 20% in U.S. stocks via VTI, and the final 20% in international stocks via VEU.

Don’t want to go it alone? If the thought of opening a discount brokerage account and buying ETFs on your own fills you with fear and trepidation, don’t worry. You wouldn’t be the first to feel daunted by the task. I still remember that my first trade, back in the day when you had to phone a real trader, was rather nerve-wracking.

Besides, if you’d like a little guidance you’re in luck: when your portfolio moves above $100,000, advisers will start to take an interest. Problem is, their advice often comes at a steep price. To help you out, I’ve sleuthed out a few ways you can get the basics without spending an arm and a leg. You might not get expensive wine and cheese service, but you will get core asset allocation advice and a friendly hand to help you build a customized portfolio.

One good choice is to enlist the services of investment management firm Phillips, Hager & North. PH&N is the granddaddy in the field and it still represents good value. The firm offers a very broad line of low-fee funds and when you sign up directly with them, you can get a dedicated adviser, portfolio planning, and a long-term investment strategy. All of which is included in the already low cost of their funds.

Another option is Steadyhand, a new entrant run by PH&N alumni Tom Bradley. You get the benefits of his experience, but you also get advisers who are still hungry and thus likely to work harder for you than others who may have had a few too many ice cream cones. Portfolio strategy is included with the low cost of their funds, and Steadyhand’s fees fall as your portfolio grows. At $100,000 you already get a discount and there are more discounts to be had at higher levels. In a break from usual practice, their fees also decline based on how long you’ve held their funds.

Getting started with stocks
At the other end of the spectrum, you might want to take a more active approach and start picking your own stocks. While it might not be the right thing to do for many investors, it would be hypocritical of me if I didn’t say that it can be great for some.

If you’re just starting to buy your own stocks, I suggest moving slowly for the first few years. The experience will likely to be educational and you don’t want to make mistakes with the bulk of your money.

Thus at first you should keep the core part of your portfolio in a good low-fee balanced fund, or a Couch Potato portfolio, and then supplement that with a handful of stocks. Put at least 80% of your money in the core and at most 20% in individual stocks.

Which stocks should you start with? I suggest large Canadian dividend stocks, preferably in different industries. While you can go wrong with big dividend stocks—I’m looking at you Yellow Media—they’re generally less volatile than their smaller brethren. Large businesses with good credit ratings also tend to have more staying power than smaller outfits. To whet your appetite, I’ve highlighted five in 5 great stocks to start out with, which show promise at the moment.

Start slowly when learning the ropes to figure out if buying individual stocks is something you really want to do. As your portfolio and experience level increases, allocating more money directly to stocks becomes reasonable. Just be warned, successfully picking your own stocks is harder than it looks and requires a great deal of patience and discipline. But if you have some aptitude for it, the returns can be most gratifying.

Aside from picking up an infinitesimal amount of calculus, I met a fellow keener in class who had the investing bug. He rattled on and on about odd things called mutual funds and how you could make a potload of money from them. Naturally enough, I promptly forgot about funds for about a decade while exploring calculus a bit more. But I rediscovered them after I had amassed just over $10,000 by playing the part of Beaker to a series of lovable Dr. Honeydews in a variety of laboratories.

At the time, I felt that $10,000 was a tidy sum for a young fellow—enough to think about alternates to a bank account anyway. So after some pondering, I moved my grubstake into mutual funds. If only I knew then what I know now. But you can profit from my experience. Here’s what I’d tell a younger me about investing, if I had the chance.

The importance of fees
To begin with, there are only a few things that you can really control when heading to the market to make your fortune. It is important to realize that the market is just there. It doesn’t care if you make or lose money—and there are many ways to lose money.

That’s why you should launch your offensive for profits from a secure foundation. Instead of immediately seeking the very best opportunities, it can pay to aim to limit your losses. And it shouldn’t come as a surprise that fees are an important source of such losses. To make money from a small base it helps to be thrifty because many financial institutions seem to prey on the middle class and poor these days.

To highlight how important keeping costs down can be, let’s look at the miracle of compounded interest. The notion is simple. If you can grow your money—even at a low rate—over a long period, then you too can be rich as Croesus. More concretely, if you grow your $10,000 nest egg at 4% a year over 30 years, you’d have just over $32,400. Both higher rates of return and longer investment periods would improve your results considerably.

But unfortunately, all too many investors don’t realize that their funds charge annual fees—and the effect of those fees compounds too. A fund’s fee will rarely be highlighted as part of a sales pitch, but you can spot it in the fund’s prospectus, or you can look it up in your fund’s fact sheet online. It’s called a management expense ratio, or MER. Usually, if fees are mentioned, they’ll probably be referred to in some diminutive fashion. Something like: “It’s only 2%, just think about how much money you’ll make.”

It’s true that 2% doesn’t sound like a lot, but let’s say that you hold a mutual fund for 30 years and it earns 4% a year, on average, before fees. That means that almost half of all of your growth will be snatched back from you in fees. As a result, your $10,000 would grow to about $18,100, which is a good deal less than $32,400. That’s why it’s well worth your time to keep an eye on costs—after all, annual fund fees in Canada are often in the 2% to 3% range.

Three enemies of growth
Taxes are another bane to investors. Despite the government’s desperate need to fund new $400-million hockey arenas in Quebec and G8 gazebos in Ontario’s cottage country, I suggest structuring your affairs so as to minimise taxes as far as is both sensible and legal. For most people, the best way to pay less tax over the long run is to hold investments inside a Tax-Free Savings Account (TFSA) or an RRSP. Outside tax-sheltered accounts, taxes can act a bit like a 2% to 3% annual fee on stock returns over the very long term. Interest income from bonds and GICs is taxed at an even higher rate.

I hate to bring it up, but next I must address an even more insidious way that you can lose your hard-earned savings. It is called inflation. That’s the tendency of money to lose purchasing power over time and it is generally caused by the government printing too much currency. Inflation is the reason why ice cream cones cost 10 cents in the distant past whereas now they cost $3. These days inflation is running at 3.1% annually, which means that even if you avoid the risks of the market by stashing your cash under your mattress, you’re still losing 3.1% of your money’s value every year.

There’s one more threat to your growing portfolio: Your own behaviour. Specifically, it’s the tendency we have to buy high and sell low. Most people can sit in a savings account and sleep well at night. But they seem to lose their heads in the stock markets and it’s easy to see why. The markets gyrate and plunge frequently. In early 2009 many investors woke up to discover that their portfolios were only half as big as they were a couple of years earlier. Problem is, very few investors seem to dive in and actually buy low during such downturns. More commonly purchases are made after a good rally, and investments are sold after a big decline. As a result, history has shown that investors lose—very roughly—2% a year over the long term due to such behaviour.

So let’s do a rough summary: Fund fees might reduce your returns by 2.5% a year, taxes another 1%, say inflation nibbles off 3%, and bad timing another 2%. Gulp! Unless your money is earning an annual return of more than 7.5%, your savings could actually be shrinking. How can you avoid this nasty fate? By minimizing taxes, fees and bad timing.

So where should you invest? I’ve already suggested making use of TFSAs and RRSPs to reduce taxes, but what about fees and bad timing? The solution for the vast majority of investors is the humble low-fee balanced fund. It’s the unsung star of the investment world.

Balanced funds are a one-stop shopping experience for portfolios, and they hold a diversified selection of both stocks and bonds. Usually such funds invest about 60% in stocks and 40% in bonds, or equal amounts in both stocks and bonds.

Because balanced funds contain a big dollop of bonds, their returns tend to be much less volatile than those of stock funds. As a result, it is usually much easier to sleep well at night. You might lose a bit during market crashes, but the declines will be more palatable that those from stocks alone. History has shown that most investors handle balanced funds relatively well and don’t suffer too much from the buy-high, sell-low syndrome. That helps to minimize your losses from bad investing behaviour.

Even better, if you look for them, you can find excellent low-fee balanced funds in Canada. Because I know many people like to deal with their bank, I’ve picked a solid low-fee balanced fund for each of the big banks in 8 great funds to stash $10,000 in. I also included a couple of excellent funds from Calgary-based Mawer Investment Management. You can get both Mawer funds with a $5,000 initial investment through a discount broker, or wait until you have $50,000 and invest directly with Mawer to avoid the brokerage fees.

Since the beginning of the year, several key developments have helped to boost the outlook for oil and gas prices. First and foremost is the recurring risk of inflation.

The unwillingness of governments to cut their budget deficits has made higher prices all but certain in most developed countries. In the U.S. in particular, the mounting deficits and debt are untenable. But instead of cutting expenditures and raising taxes, which is politically suicidal, governments seem to be inducing inflation to make debt easier to repay.

For the same reason that inflation is harmful to savers, it’s good for long-term debtors, because it lowers the real value of the interest payments. That’s why governments with high debt have an incentive to encourage inflation. In his book The Age of Turbulence, Alan Greenspan forecast a 4% inflation rate for this decade, mostly due to structural budget deficits. (A structural deficit is one that cannot be eliminated without major taxing and spending policy changes.) But that was before the crisis of 2008. With the binge spending and loose monetary policy of the past three years, inflation is likely to get worse than 4%. Prices are currently moderate on most consumer items, so this sounds like next year’s problem. But markets anticipate what will happen next.

The problem is, inflation and high commodity prices — including oil and gas prices — tend to feed on each other in a vicious circle: people stock up on commodities to hedge against inflation, which leads to even higher prices, and thus inflation continues to rise.

The second development that bodes well for energy stocks is Japan’s nuclear crisis. After what happened in Fukushima, nuclear energy has suddenly become unattractive, both politically and environmentally. The obvious alternative is natural gas, which will increasingly replace nuclear reactors for generating electricity.

The third development is political uncertainty in the Middle East. Recent events in this region, which produces about one third of the world’s oil supply, have pushed oil prices above $120 per barrel.

Needless to say, higher prices do wonders to the profitability and cash flows of oil and gas companies. For these companies, the cost of production is pretty much constant, so every extra dollar in the selling price goes straight in their coffers.

Right now large oil and gas companies are trading at cash flow multiples of 9 to 10 times, which is on the high side. However, when recent price increases are factored into this year’s results, those multiples will suddenly look much more attractive.

As Canadian investors, our options for getting oil and gas exposure abound. To start with, the S&P/TSX Composite Index is more than 25% energy stocks. So even a broad-market Canadian mutual fund may have more than enough oil and gas exposure for a regular investor. But if you want more, you can always buy an energy fund.

There is no separate investment category for energy funds: they’re typically included with natural resources funds. But in the graph Cooking with gas I have provided a list of pure, actively managed energy funds for you. In order to select a suitable one, first consider whether you want purely Canadian exposure, or whether you prefer to diversify into global energy funds.

Keep in mind that the moment you go global, some additional risk factors come into the equation, including foreign currency fluctuations. Historically, the Canadian dollar tends to appreciate with higher commodity prices, as Canada is largely a resource-based economy. Therefore, investing in a fund with exposure to foreign energy stocks is a bit like a tug-of-war: some of your gains may be offset by currency depreciation.

Your second consideration is whether you want a fund with small-cap or large-cap focus. Small energy companies produce less and have fewer exploration fields, so when they have a major strike, their price skyrockets. They also tend to benefit more from higher prices. On the other hand, those companies have limited access to financing, and less capacity to withstand long cyclical
downturns. In summary, investing in small-cap producers can be very rewarding, but it’s not for the faint of heart.

Looking closer at Cooking with gas, you will see that CIBC Energy and Bissett Energy have scored the best results, buoyed by high exposure to Canadian small- and mid-cap companies. RBC Global Energy also has some focus on smaller companies, but the non-Canadian component of its portfolio has suffered from the rising Canadian dollar. The fourth-best performer, Altamira Energy, places more emphasis on mature, large-cap Canadian producers. For that reason, it is slightly less volatile than the other two.

No matter what you choose, keep in mind that energy funds are almost twice as volatile as regular equity funds. Even though the long-term outlook remains promising, you can never ignore the risk of a cyclical downturn. Energy funds lost 40% or more of their value between June 2008 and March 2009. That’s an indicator of how bad things can get when the market turns against you.

For the risk-conscious investor, the ideal alternative is a fund that invests in high-yield energy stocks. The beauty of these funds is that they can cope with most economic situations. When the economy is strong and inflation is high, interest rates go up, but so do oil and gas prices. That strengthens the balance sheets and cash flows of energy companies. When the economy is weak and inflation is under control, lower commodity prices negatively affect cash flows and may result in dividend cuts. However, this risk is mitigated by the likelihood of lower interest rates, which makes dividend yields more attractive. Either way, financially sound, high-yield energy stocks tend to fare well.

In the good old days, when income trust funds were still around, it was easy to find one with exposure to high-yield energy stocks. Until last year, we had a respectable number of income trusts with high energy exposure yielding 7% or more. When the new tax laws came into effect, those trusts converted into corporations. Meanwhile, income tax and higher share prices have reduced dividend yields by half (when the share price goes up, the dividend yield goes down), but those yields are still attractive.

As a result of the mass conversion of income trusts into corporations, the former income trust funds have now morphed into balanced funds, high-yield funds, or small-cap funds. So you need to dig deep to find those with significant exposure to high-yield energy corporations.

For that, you have to look at the portfolio holdings as well as the dividend distributions of each fund. I stress the word dividend here because mutual fund distributions include several components: dividends, capital gains and return of capital. What matters most is the dividend income, because these payments come from surplus cash flow. Capital gains are more unpredictable, and return of capital is simply your money being handed back to you.

Separating out the dividend distributions from the others sounds tedious, and it is. However, you don’t need to worry, because I’ve done the work for you. In the graph “A safer bet,” I have listed six options with a healthy exposure to high-yield energy stocks. I selected funds with a minimum estimated portfolio yield of 2% and a minimum exposure of 30% to the energy sector. This is to ensure that a substantial portion of the dividend income is derived from energy stocks, which makes the fund less vulnerable to inflation.

If you want a lower-risk alternative to hedge against high energy prices, I would suggest that putting some money (say 10% or 15% of your portfolio) in one of these funds is a suitable choice.

But it’s different now. Really. Technology stocks are no longer grossly over-valued, for starters. The whole sector has come crashing down to earth. Not only is the sector more attractive by historical standards, but arguably, compared to most other market sectors as well.

Today, the average price-to-earnings (P/E) ratio of a typical U.S. technology mutual fund is 21 times. That’s approximately half of what it was 10 years ago. In March of 2000, at the crest of the dot-com bubble, the NASDAQ Index average P/E ratio peaked at an absurd 47 times earnings. It’s true that a P/E ratio of 21 is still high compared to the overall S&P 500 average of 16. However, technology stocks have always commanded a sizeable valuation premium over other sectors, and there are some good reasons for that. You might not want to jump in with both feet, but here are five good reasons why it’s time to give tech stocks another chance:

Tech is growing fast
Forrester Research estimates IT spending will grow by 9% this year and 7% next year. Compare that to the expected GDP growth of 2% or 3% for the overall economy. As well, technology companies are projecting an average earnings growth of 15% to 20% next year, versus 7% or so for the broad market. Investors expect the faster growing earnings to catch up with higher stock prices, which justifies the higher P/E multiple.

Even better, that valuation premium isn’t as high as it appears to be. These days many technology companies have tons of cash on their balance sheets, averaging between 10% and 20% of their market capitalization. Microsoft, for example, has cash assets representing some $4 per share. That means if you bought the company’s stock today at $25, you’re really only paying $21. After adjusting the price of the shares for the value of the cash on hand, Microsoft’s P/E ratio drops from 12 times to 10 times. Several technology stocks have become so cheap that they are now considered true value picks. Because of all that cash, the average technology P/E ratio is actually more like 18 or 19 times, not 21.

Tech is transparent
Tech companies got a bad rap during the dot-com bubble for promising the moon before they even had a penny in earnings. Internet darlings that actually lost money on most of their sales still saw their stock prices shoot up (remember Pets.com?). But today it’s easier to understand a tech company’s earnings reports and balance sheets than those from companies in other sectors. Some five years ago, new accounting rules paved the way for cleaning up the stock options fiasco. Since then, earnings reports have become more transparent, with less room for accounting shenanigans. Unlike banks, which have a zillion ways to hide bad loans, or commodity-based companies, which use complex models to estimate the value of their reserves, technology companies’ earnings are largely made up of simple, pure cash flow.

Tech is (almost) recession-proof
Technology products have increasingly become part of our daily life. These are no longer discretionary spending items: in many businesses, if you don’t have a BlackBerry or an iPhone you can’t compete. Our unwillingness to give up such technology once we’ve grown accustomed to it has made the sector more defensive in nature, and more resistant to economic down cycles.

Yes, companies may put off upgrading their computers, software, routers and servers during times of hardship, but they won’t give them up altogether. Besides, corporate balance sheets are flush with cash right now—unlike debt-laden consumers and governments. Right now corporations are capable of spending big bucks on technology to improve productivity, making tech one of the few sectors that could see above-average growth despite the current hard times.

Tech is global
Technology has innovation on its side, and that boosts both productivity and demand. (How many people do you see lining up for a new detergent or soft drink formula the way they do for the latest iPhone or iPad?) That excitement is spreading around the world. In fact, the sector is now considered a second-tier play on emerging markets growth. As consumers in India and China become wealthier, they’re quick to upgrade the technology they use. Those markets present a phenomenal opportunity for many sub-sectors, particularly telecommunications equipment. Despite cut-throat competition between Apple, Research in Motion and Google, all three of them are enjoying strong growth in global smart phones sales.

Tech pays dividends
Believe it or not, some tech stocks are becoming dividend cash cows. Distributing surplus cash—as opposed to retaining it for growth—is becoming increasingly engrained in the corporate culture of the larger, more mature technology players. Microsoft’s dividend yield is currently 2%, similar to the overall market yield. Intel is yielding a juicy 3%. Other high-tech companies that used to pour all of their surplus cash into research and product development are likely to follow suit.

Of course there are risks too. You probably don’t want to invest too heavily in tech if diversification is important to you. Just a few large players make up the bulk of the sector’s market capitalization. Apple, for instance, currently represents a full 20% of the NASDAQ Index. The Dow Jones U.S. Technology Sector Index is also top-heavy, with the five largest member companies representing nearly half of the portfolio. Similarly, in Canada pretty much all of the S&P/TSX Capped Information Technology Index is made up of just five companies, no more.

So while the long-term prospects of the big technology indexes are good, short-term, investors could be in for some serious volatility. If you don’t have the stomach for wild roller coaster rides, a more diversified, actively managed mutual fund might serve you better than a passive index fund, as the fund manager can help to smooth things out.

In the “Tempting Technology,” chart below, I list some actively managed technology funds that have managed to report positive returns over the past five years—despite the massive losses incurred in 2008. If you look at their top holdings you will see the same index heavyweights: Apple, Google, Microsoft and Cisco. I recommend them as a good way to get some technology exposure, as they are more diversified than the index funds. Keep in mind, though, that higher growth always comes at a cost—so even the best technology mutual funds will have a tumble or two along the way.

Tempting Technology

These funds are a great way to increase your tech exposure.

Barry Cerny, 53
Retired air-traffic controller
Fairmont Hot Springs, B.C.

I grew up in Calgary and lived there all my life. I started as an air-traffic controller when I was 21, and after 30 years I wanted out. My wife Kim and I moved out here when I retired two years ago, so we could enjoy hiking, biking, kayaking, windsurfing, golfing, you name it.

I look after the finances for both of us, and I have always invested directly with mutual fund companies. About five years ago I put Kim’s investments in Mawer mutual funds, and I moved my own account there three years ago. Before that I was with Phillips, Hager & North, another good company with low fees.

I’ve pretty much been my own adviser with Mawer. Nobody pushes me to invest in something I don’t want, like stockbrokers I’ve had. They’re hands-off: they don’t contact me unless I contact them.

Before I switched to funds, I had a discount brokerage account and I was trading some individual stocks. It was okay, but it just never went that well for me. I’m more comfortable where I am now, with low-cost mutual funds that have a good record. I like that the funds are professionally managed by analysts who are watching the stocks every day.

…..

No financial product has had more impact on small investors than mutual funds. It’s easy to see why. They offer Joe and Jane Investor a chance to hold entire portfolios of stocks and bonds that they could never have assembled on their own. They’re easy to buy, either through your bank or through an investment adviser. And best of all, it’s a snap to set up automatic contributions to your funds every month, which makes saving almost painless.

Actively managed mutual funds also give investors the opportunity to earn market-beating returns and get protection from big losses during bear markets. This gives many people comfort—knowing that their money is being managed by a professional can make them less likely to bail during a downturn.

“I believe that mutual funds and advice are needed,” says Ken Kivenko, an investor advocate and the creator of CanadianFundWatch.com, adding that many people simply aren’t equipped to invest on their own without some professional help. But he warns that mutual fund investors face hurdles. “It’s possible to be successful, but you need to protect yourself. The bear traps are everywhere.” Here’s how you can avoid them:

Choose only low-cost funds. Canadian mutual funds often charge a management expense ratio (MER) of 2% to 3%, among the highest in the world. Even a 2% fee means you’re paying $1,000 a year for someone to manage a $50,000 portfolio, and over a lifetime that can easily eat up one-third of your returns before costs. As a rule, you shouldn’t pay more than 1% for a bond fund, or more than 1.5% for an equity fund. Insist that your adviser tell you the MER of every fund in your portfolio and ask if there are lower-cost alternatives. Don’t make the mistake of thinking that higher fees mean better management, and therefore higher returns. The reality is almost always the opposite.

Use an unbiased adviser. Kivenko argues that when mutual fund dealers are paid by commission—and most of them are—they have an inherent conflict of interest. A fee-for-service financial planner—who is paid directly and transparently by you—can provide unbiased recommendations for low-cost funds, as well as comprehensive retirement and tax planning. (See MoneySense.ca for a list of fee-only advisers.)

Consider investing on your own. Buying mutual funds on your own takes about as much financial savvy as paying your bills online. You can open an account directly with a low-cost fund provider such as Mawer, Steadyhand or Phillips, Hager & North and set up an automatic contribution plan. (Minimum account sizes range from $10,000 to $50,000.) Or you can assemble your own portfolio by opening a discount brokerage account through your bank. This will allow you to buy “D Class” funds, which do not have embedded fees earmarked for advisers. Using either of these methods, you can build a mutual fund portfolio with an annual cost of about 1%, less than half what you’d pay through an adviser.

Take a load off. “Loads” are mutual fund sales charges, and they come in two forms. Some funds charge a front-end load, an upfront fee of about 5%. Others levy a deferred sales charge (DSC), which is deducted when you sell the fund. DSCs typically start at 6% if you sell the fund within the first 12 months and get gradually lower for several years until they finally hit zero. Whether you choose to work with an adviser or on your own, it’s not necessary to pay these fees. There are plenty of no-load funds available, even from the big banks.

Monitor your performance. Kivenko suggests asking your adviser for your personal rate of return at least once per year. This isn’t as straightforward as it may sound. If you’re making monthly contributions, it’s difficult to know how much of your portfolio growth is from investment returns and how much is simply the money you’ve added. “A lot of advisers don’t understand how to do dollar-weighted returns,” Kivenko says. “But if you are in the business of giving advice, then a minimum requirement should be the ability to measure that advice.” Compare your personal rate of return with the appropriate benchmark: for example, compare your Canadian equity fund to the S&P/TSX Composite Total Return Index. If your funds return less than the overall market, why are you paying a fund manager?

What returns can you expect? We’ve graphed the average performance of balanced mutual funds before fees above in The complete package, above (data courtesy of Fundata Canada). The average annual return since 1980 is 10.4%, better than the appropriate mix of benchmark indexes, so the managers of these funds have definitely added value. However, as the line in dark green shows, after the fees are added in, the mutual fund performance drops below that of the Couch Potato indexing portfolio (see page 44). One thing to keep in mind is that both the Couch Potato and mutual fund strategies include bonds, so they shouldn’t be compared directly to an all-stock strategy.

What can go wrong? Even if you’re investing in low-cost funds, you still need the discipline to stick to your strategy. Investors love to chase performance by buying last year’s best performers, which virtually guarantees dismal results. According to the research firm Dalbar, equities returned 8.2% annually over the last 20 years, but typical equity mutual fund investors earned barely 3% because they jump in and out at the wrong times.

One-fund solutions

The simplest way to be a successful mutual fund investor is to buy a single no-load, low-fee balanced fund. These all-in-one portfolios contain a mix of bonds and equities suitable for an investor with a moderate risk tolerance. If you have a five figure portfolio and the discipline to make monthly contributions, it’s hard to go wrong with this strategy. These excellent funds can be purchased directly from the fund company or through a discount brokerage.