The Key Differences Between Mutual Funds and Segregated Funds

A mutual fund is simply a basket of individual stocks managed by either a manager or a team of managers. The team will select various investments to hold inside of the fund in order to create a return for their investors. Typically the mutual fund will earn interest, dividends and capital growth over time and the fund's value will increase.

The manager may have the mandate to invest in a geographical region such as Canada, the USA or Europe. The mandate may stipulate a certain percentage of its money be in fixed income and a certain amount of equities. Some mutual funds have 50 stocks and some may have 400. The fund will usually list its top 10 holdings at any one time. Each fund has to provide the investor with what is called a prospectus. This document details the fund's mandate, objectives, fees, risk profile, etc.

Mutual Fund Fees

Obviously, the managers of the fund have to pay for an office and all of the expenses related to running the fund. Office, staff, research, travel, computers and reporting requirements. The management expense ratio is the percentage of the fund's growth that goes to pay for the expenses related to running the fund. Most mutual funds have an MER in the range of 1.75 - 3%. In order for a fund to have investors, the manager has to have a way for investors to know the fund exists so they use dealers that have advisors with clients. A typical advisor works under a mutual fund dealer. You may have heard of mutual fund dealers like Investor's Group, Portfolio Strategies, etc. These dealers have advisors who sell mutual funds to their individual clients. Typically the fund manager pays a 1% trailer fee to the dealer, who in turn pays a percentage of that fee to the advisor for serving their clients. If the MER on a fund is 2.5%, the fund manager may get 1.5% for managing the fund and .2% would go to the dealer and .8% would go to the advisor.

What is a segregated fund?

A segregated fund is actually an insurance contract using an underlying mutual fund as the investment and some insurance guarantees such as maturity and death guarantees, ranging from 75 -100%. This means that the insurance company is providing a guarantee that you can never lose your principal as long as you either hold your investment to maturity or upon death. So, if you invested $50,000 with a 100% guarantee and a 15-year maturity at the end of 15 years your money is still worth at least what you put in ($50,000), or the current market value, whichever is greater. You have the upside potential of growth with some downside protection. If you die during the contract your beneficiary will get the current market value if it's up in value or the minimum guaranteed amount. The maturity guarantee can be anywhere from 10 years to 25 years or more. You can partially or fully redeem your segregated fund at any time at the current market value.

The key similarities:

1. Both mutual and segregated funds can be held in all non-registered and registered account types such as RRSP, RESP, TFSA, LIRAS, RRIF, LIF's.
2. Both are bundled investments.
3. Both have market exposure.
4. Both can have equity and fixed-income investments.
5. Both can go up and go down in value.
6. Both give you access to greater diversification.
7. Both will allow you to make monthly or annual contributions.

The key differences:

1. A mutual fund has no guarantees. It's worth the current market value. A segregated has principal guarantees. Neither has any guarantees of growth.
2. A segregated fund has a slightly higher MER (.25bps), but here's what you get for that increased cost:

• Principal protection
  • Based on the level of guarantee you choose, you have between 75-100% guarantee on your initial principal invested if held to maturity or upon death.
• Resets and Locking in Gains
  • Market gains can be locked which means your base protection can keep increasing. Depending on the company, resets are available on a monthly, yearly or tri-annual basis. Some resets are automatic and some have to be done manually.
• Creditor protection
  • If your named beneficiary is an immediate family member (ie. child, spouse, parent, grandchild), then there is creditor protection available to you in the case of bankruptcy. This can be especially beneficial for business owners, wishing to protect personal assets from creditors. There are limitations, such as using a segregated fund when under financial distress.
• Estate preservation
  • Segregated funds can be quickly and privately be transferred to your beneficiary. Your will is a matter of public record and anyone can see how you distributed your estate. If you have a blended family, one child can see how much another child received and can proceed with a claim against your estate if they felt they were unfairly treated. Segregated funds can be distributed without any public knowledge.
• Probate protection
  • Because segregated funds are an insurance contract, they do not have to go through your estate and attract estate or probate fees. You can have your beneficiary receive the proceeds very quickly and cost-effectively.
• Guaranteed income
  • Many, but not all, insurance companies have options where you can take your investment and create a guaranteed lifetime income. Basically, turn your investment into a type of annuity. The older you are, the higher the monthly payout will be. One of my favourite features is that you can have a guaranteed monthly income, while at the same time be fully invested in the markets and have continued market growth. This will allow you to fund your current lifestyle and provide a greater inheritance for your loved ones.
• ​Taxation 
  • Flow-through of capital losses​

    • A mutual fund can’t flow-through capital losses. Rather, losses are subtracted from the capital gains within the fund and only the net capital gains will be distributed to an investor and shown on the T3. In a year where losses are greater than gains, the excess losses can’t be distributed and are carried forward to offset gains in a future year.

      Segregated fund contracts can flow through and report capital losses to investors. For example, in a year where there are both capital gains and losses to report, investors will have an amount reported in the capital gains box (box 21 – same as a mutual fund) and an amount in the Insurance Segregated Fund Net Capital Losses box (box 37 – only available to segregated fund contracts).

      The advantage for a segregated fund investor

      Capital losses not used in the current year can be carried back three years or carried forward to future years. In other words, an investor, not the fund, chooses when to claim any excess capital losses. Anytime you can carry back a capital loss and get an immediate refund of taxes is a benefit to you because you can immediately start using that tax savings for income or to be re-invested.

Conclusion

There's no such thing as one investment being bad or good, it really depends on the purpose you need the investment to provide. A mutual fund will give you slightly more upside growth potential because of a lower MER base, but the Segregated fund will give you market growth exposure, but with valuable downside protection.

The key is to have the right kind of investments products that you understand and will help you achieve your short and long-term goals.

We can help you create a sustainable, predictable cash flow from your portfolio in the most tax-efficient manner to ensure you never have to worry about running out of money.

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Willis & Nancy Langford

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