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Scrutinizing investments
Questions can help gain clarity

Last week, I criticized the investment industry for drawing individuals into fads at exactly the wrong times. Industry players have launched so many products that investors must sift through a lot of junk before finding worthwhile investments. However slick marketing and smooth sales pitches make it tough to sniff out the real winners. Here are some questions you should ask the next time an investment is proposed to you.

Benefits

This is the characteristic that will likely first be communicated to you. In essence, you'll want to know why you should buy the investment. What will it do for you? What role will this investment play in your overall strategy? You'll also want to get at least a broad idea of the factors or conditions under which the investment will prosper.

If you're being shown returns from past periods, don't take it too seriously unless there is a long period of time shown (i.e. at least twenty years). Otherwise, the return illustration may be skewed by the conditions in that relatively short period of time. Hence, once you're familiar with the conditions that would drive an investment to have good returns, you may also ask what conditions prevailed during the period covered in the return illustration.

If the past performance shown is that of some other investment or index because of a lack of history for the proposed investment, ask if the illustrated returns have been adjusted to reflect the fees charged in the investment being proposed.

Costs

This all-important piece of information is sometimes elusive. With mutual funds, fees are withheld at source but they're anything from free. As much criticism as mutual funds attract, the fees are pretty clearly disclosed.

However, other so-called "limited market" products like linked notes and other offerings aren't so forthcoming about their fees. I'm currently performing a compliance review on a product for our firm. I read all of the offering documents and I admit that, after reading all that stuff, I couldn' t tell you the actual fees of this product. Hey, I'm no rocket scientist, but if I can't figure out the fees on my own, how are advisors and investors supposed to do the same?

That leads us to the next question: What are the total fees, both implicit and explicit, that apply to this product? For mutual funds, explicit costs would be any sales charges and the management expense ratio (MER) - both of which are charged directly to your account. Implicit fees would be brokerage fees incurred in buying and selling stocks. Brokerage fees (which are excluded from the MER) are included in the cost of securities purchased, and the proceeds received from stock sales. Another implicit fee for some mutual funds - called RSP clone funds - are those related to the customized instruments (i.e. forwards and swaps) used to achieve their objective.

Even index-linked GICs have an implicit cost. The banks limit your upside potential in return for a guarantee of principal. Remember, there is no such thing as a free lunch.

That's a very quick rundown of the costs involved in mutual funds, but it's a good question to ask no matter what the proposed investment.

Risks

You're really after two things here. First, find out the factors or conditions that will cause the value of the investment to fall. Second, ask for a worst-case scenario of how the investment should be expected to perform (or how it has in the past) under such a scenario.

You'll also want to get an idea of how well correlated this investment is to what you already hold. This will give you some idea of the diversification benefits you may receive by holding a particular investment.

Finally, it's worth asking if the investment contains any explicit or implicit leverage. For instance, many limited partnerships actually involve an investment plus a loan agreement. Hedge funds and managed futures, on the other hand, often use leverage at the fund level or buy derivatives, like futures, that are already leveraged investments.

Liquidity

For some, this will be a critical factor. Are there restrictions as to when you can liquidate your investment? If you get a response like, "if you're in for the long term, it doesn't matter"; respond by saying that even though you may not intend to cash out before a certain time, you'd like to become more familiar with the characteristics of the investment.

When you do liquidate part or all of your investment, are there any charges for selling? For instance, labour sponsored funds can be liquidated at any time, but the generous tax credits given at purchase must be repaid if cashed out within eight years - during which time additional redemption charges will also apply.

Alternative investments, like hedge funds or linked notes usually have some liquidity constraints. Hedge funds usually only offer the chance to sell once monthly but also require some advance notice. Some linked notes may have an initial holding period; with specified dates upon which investors may submit sell orders.

Tax consequences

This is only a concern outside of a RRSP, RRIF, or other tax-deferred savings plan. If an investment has much of a history (in both good times and bad), ask for a summary of the taxable income (and types of income) it has generated in the past.

If an investment is being sold primarily on its tax benefits, ask whether an advanced tax ruling has been obtained. If not, ask to see a copy of a tax opinion before investing. A tax opinion is no guarantee that the "expected" tax treatment will hold up if ever challenged by CCRA (formerly Revenue Canada).

Investments offering big tax benefits are usually risky.

Conflicts of interest

The trend in the fund industry is to marry distributors (i.e. dealers and financial advisors) with manufacturers (i.e. companies that manage and offer the funds). It wouldn't hurt to ask if the investment being recommended has any ties whatsoever to the advisor's firm or the company that sponsors the advisor's license. In Ontario, if the product manufacturer is owned by the distributor (i.e. Assante owns Optima Strategy and Artisan funds), a disclosure form is usually required to be presented to and signed by the client documenting the existence of potential conflict and the client's acknowledgement thereof. Take your time to read this document - don't feel rushed.

Finally, it may be useful to ask about the implications from an estate planning point of view. What happens upon death? Can it be transferred to a beneficiary? How are some of the above items treated in the case of death - i.e. liquidity and mandatory holding period?

This list won't address every issue that applies to each person, but it should serve as a good checklist of questions to ask your advisor the next time an investment is proposed.

I've said it once, but it's worth repeating: There is no such thing as a free lunch.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...