The Trouble with Fund Fees

In 2012 the Canadian Securities Administrators (CSA) issued a request for comments regarding mutual fund fees. Their goal was to determine whether any regulatory action was required, partly because Canadian mutual funds bear the dubious reputation of being among the most expensive in the world. How can Canadian investors build a portfolio and ensure that as much of the returns as possible makes it to their bottom line? This brief discussion illustrates some problems with high mutual fund fees and suggests some ways to keep them down.

Mutual fund fees are important. If two investments offer the same return, the one with the lower fees will result in more wealth for the investor. A recent article by Nobel laureate Bill Sharpe shows this issue clearly. This paper uses a lot of math, but in essence Sharpe is saying that unless the more expensive fund provides higher returns than the cheaper fund, a retiree could expect as much as 20% less wealth at retirement by having chosen expensive funds. (You can find a link to the full paper in the citations section.)

The chart below shows how much total wealth an investor would accumulate over a 30-year horizon by investing in a portfolio with fees of 1%, 2%, and 3% if all portfolios provided the same return. As you can see, fees really matter to your ultimate investing success.

 investor-wealth-over-30-years

Source: Dimensional Fund Advisors

The management expense ratio of a fund may not tell the whole cost story, either. Funds trade more or less actively depending on style and strategy. Trades cost the fund commissions, and each stock trade also subjects the fund to the difference between buying and selling prices (called the bid and ask prices). Finally, large trades can actually affect the market price of a security and move it up or down disadvantageously. So-called “active” funds are more likely than “passive” funds to incur such costs. We describe these fund types later on.

What if you believe your more expensive fund will outperform a cheaper choice over time and therefore compensate you for the higher fees? The odds are against you. (See the article by Sharpe regarding active management). Every year Standard and Poor’s publishes its Index Versus Active report and Persistence Scorecard. Every year, these reports show that the majority of active mutual fund managers underperform their reference markets. Furthermore, top performers do not stay at the top for long. So unless you can gauge which funds will do best in advance of their performance, it is unlikely you will consistently benefit from having the top performers in your portfolio. Instead, you will probably have paid high fees for no financial benefit.

Of course, not all fund companies view their fees in that light. In Canada, the advisor’s compensation generally comes from the product (e.g., the “trail commission”), and so one could argue that half the fee is for the advisor’s services and the other half is for management. On the surface, this seems fair. But according to the CSA report, Canada has no formal standard for the services an advisor must provide when receiving fund commissions. So how can a consumer realistically determine a fair value for the advisor’s services—especially when given no choice to separate the advisor fee from the money management fee?

Mutual fund fee structures can also lead to conflicts of interest. An advisor’s compensation may differ depending on which share class you buy. For example, the advisor could earn a higher commission by offering you a share class with a sales charge up front versus one with a redemption fee later. Or the advisor could be aligned with a bank and have a financial incentive (or even obligation) to offer bank products, even if other companies have better funds. In fact, despite the obvious expectation that the advisor will consider the investor’s interests first, many advisors are not legally required to follow a fiduciary standard in Canada. A tempting fee structure can create “gray areas” for the advisor when one investment type leads to a larger bonus. A compensation structure that aligns an advisor’s interests with those of clients is typically the structure clients should be asking their advisors for.

You may wonder, what is a reasonable fee for a fund? In general, “active” funds cost more than “passive funds.” An active manager analyzes markets for potentially undervalued securities and buys them in a mix which varies from the overall market. By contrast, a passive manager purchases all securities in a given market and simply lets the average returns play out. As you can imagine, active funds cost more because they have to attract and retain top talent, pay large bonuses and sales commissions, and pay for research. Passive funds can execute their strategy at a low cost because they require far less research expertise. Remember that high cost analysts and expensive software to pick the “best” securities, has been shown empirically not to produce superior results after expenses.

The typical Canadian management expense ratio (MER) is 2% of assets for an equity fund with an embedded “trail commission” (see page 13 of the CSA report). Sometimes advisors or banks offer discounts to these fees, but even then you might pay more than 1% MER on an equity fund. The CSA reports give the typical management fees from their study (data originally from Morningstar):

typical-management-fee-mutual-fund

By contrast, some low-cost passive funds have entered the market recently, and we believe that in time the competitive pressure may help other MERs to come down. For example, Vanguard recently introduced some exchange-traded funds in Canada. Their Canada Index fund (VCE) costs only 0.09%, and even their emerging markets fund costs only 0.33%. A typical active fund would probably have to outperform the Vanguard fund by at least 1% per year, every year, to compensate for its higher cost. Given what we know about history, we do not expect many managers to boast that kind of skill.

The KeatsConnelly approach

KeatsConnelly stands out against many other Canadian advisors in several ways:

First, we accept compensation only from our clients and receive no commissions, kickbacks, referral fees, or other tangible benefits from the companies whose products we recommend.

We hold ourselves to a fiduciary standard and know what that entails because our staff members maintain many industry designations, each with its own code of ethics. We are a truly independent firm concerned about our clients’ tax, financial planning, and investment management needs.

While we do charge a management fee based on assets, our clients always know exactly what they are getting for that fee, and our costs remain very competitive in the Canadian market.

As of our most recent review, more than half the funds we use showed MERs below 0.50% and all of them priced under 0.75%. Because we select primarily passive funds, we can ensure you keep more of the markets returns after fees.

Most funds we select come from independent fund companies that have demonstrated good shareholder culture. Because bank-owned funds exist to provide profits to the bank, their pricing may be higher than what a fund might normally cost.

We encourage you to contact us so that we can present the KeatsConnelly approach to investing and answer any questions you might have. You will find we have a very transparent investment philosophy and can help you look at your portfolio through a clear lens of best practices.

 

References

Canadian Securities Administrators, A Comparison of US and Canadian Mutual Fund Fees – December 13, 2012.

Sharpe, W. F., “The Arithmetic of Investment Expenses,” Financial Analysts Journal, Vol. 69, No 2, March/April 2013: 34-41.

Sharpe, W. F., The Arithmetic of Active Management,” Financial Analysts Journal, Vol. 47, No 1, January/February 1991: 7-9.

Standard and Poor’s, SPIVA® Canada Year-End 2012.

Standard and Poor’s, Persistence Scorecard: July 2013.

Cross-Border Series
The Border Guide
Now available in its 11th edition, The Border Guide has sold over 80,000 copies and is considered the definitive cross-border financial tool for Canadians living, working and investing in the United States.
A Canadian's Best Tax Haven
This book will show you how to realize your dream of living a lifestyle in a climate that allows for year-round golfing and sandy beaches while lowering your taxes and cost of living.
Taxation of Canadians in America
This book addresses individual US taxation and estate planning issues you will face as a Canadian living in the US.
Taxation of Americans in Canada
US citizens and green card holders are subject to US tax regardless of where they reside in the world. Are YOU at risk?
Crossing the Border?
TRY OUR CROSS-BORDER FORUM »
Get Updates from Us
SIGN UP FOR E-UPDATES »

Upcoming Workshops
WORKSHOP/SEMINAR DETAILS »