Corporate Class Funds

If you hold mutual funds outside your RRSP, you're probably well aware of what happens when you sell a fund. If your fund has increased in value since you bought it, the government claims a big chunk of your profits as capital gains tax. Wouldn't it be nice to defer those taxes until much later, just as you do with investments inside your RRSP?

I have good news: there is a way to sell your funds and defer taxes on your capital gains, and it doesn't involve anything complex like offshore investing. All you have to do is buy corporate-class funds, also known as switch funds. These mutual funds resemble regular funds in every way, but with one big difference. When you sell a switch fund, you don't pay any capital gains tax if you keep your money invested in the same fund family.

Think of these funds as RRSPs in disguise. Each fund family – or switch fund series – is considered a mutual fund corporation, and each fund within the series is considered a different share class. If you sell one fund and buy another within the same series, you remain a shareholder of the corporation. No capital gain is triggered, therefore you don't pay any tax.

The deferral of taxes will keep your money working for you for years by compounding returns within your portfolio. When you eventually unwind your investment – perhaps upon retirement – your income will probably be much lower than it is now and you'll pay less tax on your gains. By my rough calculations, the tax savings from a portfolio of switch funds would probably boost your investment returns by about 0.5 percentage points every year (assuming you are in the highest tax bracket, averaging an 8% annual return and turning over your portfolio at an annual rate of 25%). A half-percentage-point difference might look small now, but over 10 or 20 years the savings could be huge. No wonder switch funds are becoming so popular.

Mutual fund companies like switch funds as well, because they tend to keep investors loyal to a particular fund family. Over the past two years, more than 200 new switch funds have been launched in Canada, attracting some $3.5 billion in assets. You can distinguish a switch fund from a regular fund by looking for the label "class fund" in the fund's name. CI Mutual Funds refers to its switch funds as "sector funds," but that's the only exception of which I'm aware.

I highly recommend switch funds if you are investing money outside of an RRSP. However, keep in mind a couple of things before you make the leap. If you are happy with your current mutual funds, you shouldn't redeem them solely to move your money into switch funds. If you do that, you will trigger the very response you're trying to avoid: capital gains taxes.

Also, you should carefully weigh your options before committing any of your money to a switch fund. This is an important decision because you will likely want to remain within one switch fund series for many years to come. After all, when you pull your money out of a fund series, you will have to pay tax.

Unfortunately, the management expense ratios (MERs) of switch funds tend to be higher than those of regular funds. This difference can range from a modest bump of 0.1 percentage points to an outrageous full percentage point. I would not pay more than a 0.2-percentage-point premium for a switch fund. Otherwise, you will be losing much of the tax advantage. Also, keep in mind that there are some notable exceptions to this pattern of higher costs. The Templeton Growth Tax Class Fund, for example, is 0.2 percentage points cheaper than its regular counterpart.

You want switch funds that perform well over the long term. In some cases, switch funds do not have a three-year track record but are clones of other funds offered by the company.

Your switch fund series should hold funds that are not exceptionally volatile. The series should also offer a wide range of different types of funds. For example, a series that includes equity and bond funds, covering 10 or 12 categories, is better than a series that includes just six or seven equity funds. Also, a series that includes a mix of value and growth funds is better than a series that includes only growth funds. If you are a market timer or want to make bets on specific sectors of the economy, you need a pool that is rich in sector funds.

Based on these criteria, my top picks are the switch fund series offered by Fidelity Investments and Mackenzie Financial Corp. Both offer large pools of inexpensive switch funds that have performed relatively well over the past three years. I would rank Franklin Templeton's series of funds as a close second. The Templeton series is a pool of 12 funds that includes some of the best in the country, including clones of the famous Bissett Canadian Equity and Templeton Growth funds.

Although switch funds are designed to minimize the tax consequences of selling mutual funds, I would caution you against making trades too frequently. Instead, use switch funds as a tax-effective means of rebalancing your portfolio every year or so. You'll like the results.

By Suzane Abboud, from the September 2002 issue of Moneysense magazine