3 Reasons to Buy IGM Financial Inc. and 1 Huge Reason to Stay Away

For consumers, mutual funds are a pretty bad idea, at least on the surface.

First of all, it’s not that complicated to pick your own portfolio. As we relentlessly advocate here at The Motley Fool, most anybody can build a diversified portfolio filled with some of Canada’s best companies. If somebody doesn’t want to go to all the work of picking individual stocks, exchange traded funds (ETFs) are generally a good choice. ETFs have low fees, and most track the index, meaning investors tend do just about as well as the stock market as a whole.

You’d think mutual funds would be a better choice. They’re run by smart people. Managers tend to get private access to a potential investment’s management, which can yield information the rest of the market doesn’t have. And yet, most funds consistently underperform the market.

There are a couple of reasons why. Most importantly, a management fee of 2-3% is a huge handicap. If the market returns 10%, a mutual fund with a 2.5% fee has to make 12.5% just to keep pace. And secondly, huge funds with billions in assets make it difficult for fund managers to invest in anything but large companies. Thus, most funds track the index almost by default.

But just because mutual funds aren’t good deals for consumers doesn’t mean you shouldn’t invest in them. Let’s take a closer look at IGM Financial Inc. (TSX: IGM), which is the parent company of Investors Group. Here are three reasons to buy the stock, and one huge potential red flag.

1. Great margins

There’s one simple reason why investors should prefer IGM to its competitors. It has a built-in army of sales reps who specialize in attracting the type of customer who wouldn’t blink at investing in a mutual fund with a 2.5% annual management fee.

This translates into terrific margins, which are consistently greater than 25%. Other things help as well, like buoyant markets and attracting new investors, which increases assets under management. Since managing a $2 billion fund is pretty much the same as running a $1 billion fund, the extra fees generated go straight to the bottom line.

2. A succulent dividend

Although IGM’s days of growing its dividend annually stopped in 2008, it still yields a handsome 4.6%. The current payout ratio is 70%, meaning its still relatively safe, barring a steep decline in the business.

IGM’s dividend is very attractive compared to most other financial services companies. The big banks all have dividends under 4%, as do the life insurance companies. One other financial with a higher dividend is AGF Management Limited (TSX: AGF.B), but all indications are that its 10.4% yield cannot be maintained over the long-term.

3. The stock is cheap

After spending much of 2014 trading above $50 per share, the recent market sell-off has hit IGM hard. Shares dipped below $44 temporarily a couple of weeks ago, before recovering slightly to $48. The company reported nice results last week, which boosted the share price.

Of course, bears can point to one upcoming event that justifies the steep price decline lately. Let’s take a closer look at it.

1 huge red flag

Although it’s not official yet, word is that trailer fees are about to be banned by Canadian regulators.

Trailer fees are part of the management fee, used to compensate the advisor who has the mutual fund under management. Thus, the advisor gets paid without the investor knowing about it.

There are two possibilities. Either trailer fees get banned outright, or advisors are forced to disclose to clients in dollar terms just how much it costs to own a certain mutual fund. It’s easy to imagine a scenario where Investors Group sees a mass exodus of clients leaving it in search of cheaper options once they realize just how expensive the average mutual fund is. That can’t be good for business.

IGM Financial is an interesting stock. I used to own it, and only sold because of the trailer fee news. So I’d recommend you do the same, perhaps choosing a Canadian bank instead. We can help you with that, just read the report below.

Looking for something better than IGM? How about the banks?

Unlike IGM, any trailer fee changes won't cripple the banks. Funds are just a small part of their business. And, Canadian banks are considered must-have investments. After all, they're very stable, well-capitalized, and face limited competition. That said, there are concerns for the banks and their investors. In this FREE report, we cover everything you need to know about Canada's Big 5 -- whether you're already an investor or are considering buying shares. Simply click here to receive your special FREE report, “What Every Bank Shareholder MUST Know."

Fool contributor Nelson Smith has no position in any stocks mentioned.

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