Five tips for selecting the best Canadian funds to improve your stock market returns.

The best Canadian funds are specialized ETFs that aim to equal the performance of a leading Canadian market index, such as the S&P/TSX 60.

The best Canadian funds do show better long-run performance than more than half of actively managed mutual funds with long-term track records. That’s partly because index-fund ETF fees run as low as 0.10% of assets per year, compared to 2.5% or more on many mutual funds.

Advantages of the best Canadian funds

One big advantage of the best Canadian funds is that these ETFs can help you avoid the risk of choosing a mutual fund with a management style that virtually guarantees below-average long-term performance.

For example, in our view, mutual funds that pursue a trading or sector-rotation approach belong in this sub-par category. These funds’ managers try to outperform the market by betting on relatively short-term trends. This can work in any one year, say. But in any one decade, the top funds are generally run by conservative managers who focus on long-term growth in the economy.

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Another advantage of index funds is that they can give investors with limited funds a low-cost way to get some stock market exposure. These ETFs can also be a good starting point for a registered education savings plan (RESP), or an in-trust account. Many investors also consider them when they invest funds in their tax-free savings accounts (TFSAs).

Three tips for selecting the best Canadian funds for the long term

1. Beware of buying vaguely described Canadian funds

   Get rid of mutual funds—or ETFs for that matter—that show wide disparities between the mutual fund’s portfolio and the investments that the sales literature describes. Many mutual fund operators describe their investing style in vague terms.

   It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at a mutual fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. When the mutual fund takes on a lot more risk than you’d expect, our advice is to get out.
   

2. Avoid buying Canadian funds that trade in derivatives

   Some funds are set up to profit by trading in derivatives, based on studies of what would have paid off in the past five years, for example. But other market participants can also access that information. So, things are unlikely to work quite the same way for the mutual fund’s performance over the next five years.

   In the long run, derivatives trading is what mathematicians refer to as a “negative-sum game”: one player’s gain is another’s loss, minus commissions and other costs. In the end, trading derivatives costs you money.

3. Avoid Canadian fund managers who trade heavily

   Some of the most dangerous funds are those run by managers who honestly believe they can increase their performance by frequent in-and-out trading. Many of these managers fail to realize how close their mutual fund’s performance comes to disaster each year, until disaster finally strikes.

Here are two tips for buying Canadian funds

1. Get out of buying “theme” Canadian funds

   If the mutual fund has a theme that seems to be plucked from the headlines, you should stay away from it. It pays to stay out of narrow-focus, faddish funds, all the more so if they’ve come to market when the fad dominates the financial headlines.

   Theme funds like these face a double disadvantage, because they appeal to impulsive investors who pour their money in just as the fad hits its peak. This forces the manager to pay top prices— perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. These same investors are also apt to flee when prices hit their lows, forcing the mutual fund manager to sell at the bottom and lowering the mutual fund’s performance. But when a fad fades, as they all do, the fund’s liquidity dies out with it. The manager may have to dump the mutual fund’s holdings when demand is at its weakest, forcing prices lower than they would otherwise go.

2. Get out of Canadian funds that invest in bonds

   Many bond funds built great performance records in the last decade. But this was a function of the trend in interest rates; when rates fall, bond prices go up. Interest rates are low right now, but could move upward over the next few years as the economy recovers or in response to inflation fears. This is another way of saying that bond prices could fall.

   The bond market is highly efficient, and we doubt that any bond mutual fund’s performance can add enough to offset its management fees. In addition, investing in a bond fund exposes you to the risk that the manager will gamble in the bond market and lose money.

Do you use these tips for finding the best Canadian funds in your investing strategy? Share your experience with us in the comments.