Closet indexing (unknowingly paying a higher MER than needed for index- average performance) is a particularly nasty risk you can avoid by doing your homework. Fund mergers can result in you ending up in a fund that’s too expensive or with a new mandate that’s not a fit with your portfolio. A new fund manager may start remaking the portfolio in his own image throwing off taxable capital gains distributions and incurring excessive brokerage expenses. You won’t find these risks and hazards identified in any Prospectus. Here’s a few to look out for:

Regulatory malpractice risk: The goals of securities regulation is to foster fair and efficient capital markets, maintain public confidence in the integrity of financial markets. and to provide protection for investors from unfair, improper or fraudulent practices. The risks associated with the failure of a provincial regulatory Commission or SRO such as the MFDA to fulfill its mandate to legislate, regulate and enforce laws to protect mutual fund investors is called regulatory malpractice risk. According to some critics, Canada’s 13 separate provincial/territorial securities regulatory agencies don’t have enough power or resources, lack focus, move at glacial speed and dispense only wrist-slap penalties.

Fund Governance Risk: This is the risk of unduly poor returns for investors resulting from mediocre or poor fund management, excessive expenses, deficient structures, processes, systems & internal controls. The risk arises due to the inherent structure/conflicts- of -interest of a mutual fund whereby the interests of the owners of the Manager and the unitholders of the fund may not be aligned. Ex-OSC Commissioner Glorianne Stromberg enumerated these issues in a a classic 1998 report on the mutual fund industry. The jury is still out on the effectiveness of Canada’s use of Independent Review Committees to contain conflict-of-interest risk. Investor advocates are skeptical and trust regulators are monitoring.

“ Breaking the buck”: Money market funds, where the average management expense ratio (MER) is 1.03 % are scalping retail investors. Yields hover around 1 -1.5%. The issue with money market funds is that very low interest rates have squeezed pre-tax returns to below 1 % on an estimated annualized basis. Thus, fees can be significantly higher than returns. If rates keep falling, and they may have to if the economy doesn't stabilize, then returns could conceivably fall to zero and then into negative territory .If that were to happen, then fundcos would have to reduce their fees (ho, ho, ho) if they wanted to maintain the $10 base value that money market funds are set at (the funds pay out their post-fee gains as interest income). Another way this can happen is if the portfolio contains toxic securities like ABCP. According to a August 2007 holdings analysis produced by Morningstar, about one out of every 10 Canadian Money Market funds tracked by them had exposure to some of the 23 Canadian issuers of asset-backed commercial paper (ABCP) that had been placed on a watch list by Dominion Bond Rating Service (DBRS). Indeed, if some firms had not voluntarily decided to bail out their money market mutual funds and retail owners of non-bank ABCP (National Bank capped its cash settlements at $2 billion) the situation would be far worse and would have affected hundreds of thousands of people.

Loss of redemption rights If you hold a small cap or venture capital fund whose portfolio consists of illiquid stocks there’s a chance you get caught in a redemption freeze.This recently occurred with the Canadian Medical Discoveries fund. If there is an extraordinary high volume of redemption requests and insufficient cash; some time is required to liquidate holdings. Anything-small cap is harder to liquidate in this depressing market and even if liquidated, prices obtained would be fire sale. Back in the 1990’s, real estate funds collapsed due to the meltdown in the real estate market. Funds that owned brick and mortar buildings and other properties had to ban unitholders from taking their money out. The right of redemption went out the window for this entire asset class. Investor advocates have long argued that illiquid investments such as real property should not be held by mutual funds because of the right of redemption (on-demand liquidity).They are better structured as closed-end funds. Labour Sponsored funds can in principle be redeemed 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. In a Labour Sponsored fund many of the holdings may be privately held companies whose shares are illiquid. .

Manager risk: The chance that the portfolio manager will do a poor job in managing the fund portfolio of assets. This can be due to incompetence, poor supervision, slow reaction time, inadequate research and analytical tools, bad luck, investment style, diversion towards marketing activities and the method by which he is rewarded. The track record of a number of professionally managed funds including large pension plans speaks for itself. Note also that changes in manager are not always promptly disclosed so you need to be alert. It is after all, the specific manager that determines fund performance and the “professional” management you’re paying for.

Valuation risk: This is the risk that the funds’ assets may be incorrectly or inappropriately valued thus unduly overstating or understating the NAV. Real Estate mutual fund valuations are done infrequently so that unitholders may have to give advance notice of redemptions. Such funds may also be subject to loss of redemption rights in unfavourable markets.

Abusive Trading risk: This is the risk that the long-term returns of buy- and- hold investors will be eroded by market timers (Individuals or hedge funds) that trade frequently using time arbitrage or late traders (selected individuals or other firms) that are offered net asset value prices in international funds after the 4 pm North American market close. This in fact happened in 2004 and regulators required 5 fund companies to return over $205.6 million to investors whose funds had been assaulted by market timers ( hedge funds). There were however no fines, sanctions or penalties imposed and 15 companies were left off the hook altogether. Could this recur? In 2000, industry experts said it couldn’t after it had been discovered that the Transamerica NN Information Technology Fund, an international Segregated fund had been market timed.

Sales Load risks The front -end load is another hazard. While it reduces returns it is not generally considered a risk since its adverse impact can be predetermined. Published return rates ignore front- load commission payments in the calculations A DSC (back-end load) fund may constitute a significant risk to returns if you have to exit the fund before the end of the deferred sales charge period either due to an emergency need for funds, poor performance or a change in portfolio goals. A DSC fund may incent advisers to keep you invested in the fund even when it is not meeting your needs, is unsuitable or has a 3rd or 4th quartile risk-return. DSC funds may also result in you paying higher fees than if you had purchased the same fund on a front- load basis or had purchased a no-load fund. In the end, your returns can be compromised by these abusive practices.

The risks associated with high fees: Fees are disclosed in the prospectus but the long-term decompounding impact of fees is the real threat to a retirement portfolio. High MER’s gnaw away at your ability to recognize the full benefit of growing economies and successful companies. Performance comes and goes, but fees are forever. Cost has a significant impact on both reward and risk. Lower costs make it possible to earn a higher return without assuming higher risk, or to hold reward constant and reduce risk. And because the passage of time multiplies the aggregate reward, moderates the volatility risk, and magnifies the burden of cost, time interacts with each of the three special dimensions of investing. Bond funds are especially vulnerable to high fees. On rare occasions you might find a fund with a slightly higher MER (and slightly lower return) but if it manages volatility better it might actually be more suitable for an anxious investor.

Portfolio manager compensation risk: Always recognize how a portfolio manager is rewarded (under existing Canadian mutual fund securities legislation, disclosure is not required in the Prospectus or Annual Report) and how this may increase risks for the fund. A table from The Great Mutual Fund Trap succinctly illustrates the point:

The risk- taking incentives of fund managers are likely to generate greater risk than you would choose for yourself. Some portfolio managers are rewarded not only on fund performance but also if they can keep you invested anyway through exceptional marketing and public appearances. Publicly traded fund factories even throw in stock option incentives for their portfolio managers that relate to the share price of their stock rather than exclusively to their personal contribution for creating unitholder wealth. Thus portfolio manager compensation as usually practiced at most fund Companies is a hidden hazard you should understand as a mutual fund investor. By the way, you rarely hear about actual firings – the political correct words are ‘ reassigned”, “ did not renew contract’ or the like. Sometimes fund mergers force the changeout of an underperforming manager.

Conflicted adviser risk: An adviser that is more focused on his fees and sales commissions is a BIG risk, especially for small / financially-illiterate investors), perhaps even more significant than market risk Advisers who recommend unduly risky funds, load you up with DSC funds and high MER funds or, encourage excessive switching increase the likelihood that your investment returns will be sub –optimal or that you will lose money. . Lucrative trailer commissions are designed by the fund companies to motivate salespersons to keep you invested so they can continue to collect management fees. These trailers are opaquely disclosed and many investors fail to make the connection between the incentive payment motivator and the recommendations made. The trailer is subsumed in the MER thus increasing the management fee and reducing your returns.

Incompetent adviser risk: An ill-trained adviser can wreak havoc on your nestegg. Many so-called “advisers” do not have the necessary professional qualifications to construct portfolios that tie-in with the investor’s goals and personal situation (i.e. the Investment Policy Statement). They are usually on their own and not part of an "organisation". They can and do make the same errors repeatedly without knowing it and as they are judged by their superiors virtually exclusively on the money they pull in, there is seldom anybody to correct them. Then they have the temerity to compare themselves to other professionals and speak of their work as a "practice". There is little no oversight.  If a doctor takes your appendix out there is a defined process that is followed. First you are examined a few times, than there is another doctor to put you under, then the nurse readies you, somebody checks if there are no missing instruments, left behind and after they sew you up they keep an eye on you. With few exceptions ,this kind of professional care is not evident in the advisory business.

Inappropriate leveraging risk A lot has been written regarding borrowing to invest. Inappropriate leveraging can also magnify losses as well as returns. Make sure you can financially and emotionally deal with this hazard before being sold a bunch of funds. There are documented cases where investors have lost their homes, marriages and peace of mind purchasing unsuitable risky funds using borrowed money at the peak of the market. Advisers benefit greatly by your borrowing because the more dollars you have invested in mutual funds, the greater their commissions.

Tax liability risk: There are real risks to your after –tax returns due to a high turnover of fund holdings, resulting in taxable capital gains distributions. This too is predictable by examining the manager’s style and the fund’s portfolio turnover statistic as reported in the Prospectus and Annual Report. Insights about turnover are useful because portfolio managers who keep turnover low (< 30 %) tend to practice low –risk strategies whereas high turnover funds tend to be aggressive and more risky. While after-tax returns must be disclosed in the U.S., no such requirement exists in Canada. Morningstar’s web site does provide some insight into after-tax returns.

Loss of personal information: In February, 2003 Investors Group reported a missing hard drive at outsourcer IBM/ISM Canada containing information for preparing 750,000 client statements resulting in increased visibility of the privacy issue in the financial services industry. At the time, several information technology experts classified the incident as Canada's biggest privacy disaster.

Bottom Line: Mutual funds are complex securities sold through a sophisticated commission-based distribution system. There are many risks involved besides market risks. Be alert, read the prospectus, ask questions and deal only with reputable firms and advisers. Don’t just focus on pre-tax returns. Understand risks, liquidity and tax issues. Be wary of biased/misleading marketing financial pornography and “ investment seminars” where the mind can be hijacked. Ensure your KYC is a true assessment of your current situation and goals. [KYC forms provide the foundation for the adviser-client relationship at the point at which a client opens his or her account. There is no industry-wide standard unfortunately] Never forget the old industry adage-Mutual funds are sold, not bought.

We’ve tried to provide an overview of some of the undisclosed non- market-related risks and hazards involved in mutual fund investing. We add parenthetically, that new regulator proposals on mutual fund Point-of-Sale disclosure may actually make things worse by providing less information, particularly as regards risk. In future articles we’ll cover another aspect of fund investing –outright fraud