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Question:
Are segregated funds worth the extra expense?
Answer:
Whether segregated funds are worth the extra expense is in the eye of the beholder. Segregated funds are enormously popular, so obviously a great many investors do think they are worth it. Others don't. The difference is focus. Investors focus on making money. Segregated funds focus on not losing money. These are polar opposites.
Investors assume a certain level of risk in pursuit of an expected rate of return. Investments may lose in the short term, but the long-term expectation is that the investment will be worth more than it is today. If not, investors will not buy that investment.
A typical segregated fund states, if you invest $10 into the fund, and stay in that fund for seven years, you will get at least $10 back.
Some consider segregated funds to be a can't-lose proposition. But you can. If you buy something for $10 today, and then sell it for $10 seven years later, not only have you not made any money, you've actually lost money. Inflation alone will eat into the value of that $10, dropping it to the $7.59 range. In that scenario, the extra MER that you pay on a segregated fund is for a guarantee that your real losses won't exceed 24% over the seven years. A treasury bill can outperform that.
Also, for the guarantee to be operative, you have to remain in the investment. Therefore, you are also giving up the opportunity cost of forgoing better opportunities. Say the fund drops in the first year to $9 per unit. The investor is trapped in this investment for 6 more years if they want the guarantee. Alternatively, if the investor gets out early to pursue a better opportunity, the guarantee is void, so they have paid for something they didn't use.
If the segregated fund goes up in value, the realized return will be lower than an identical fund without a guarantee (the cost of the guarantee eats into the return).
In a nutshell, segregated funds' returns are lower than their non-segregated counterparts. This return sacrifice is offset by a guaranteed minimum account balance which, in real dollars, can still result in a loss. There is opportunity cost as well.
Having said that, equity segregated funds were worth their salt over the last three years, since in many cases the markets dropped more than enough for the guarantee to kick in. The question remains, do you expect equities to continue doing that for the next seven years?
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