The cost of owning the average mutual fund

[Norbert Schlenker]

In the US, the ICI is out with a report showing that (dollar weighted) full in costs of owning equity funds declined to 1.13% in 2005, with bond funds averaging 0.90%. The decline is attributed more to asset shifts to lower cost funds than to declines in MERs.

I know DanH has done some tracking of and reporting on this subject for Canadian funds but the most recent article I found on his website quotes Mark Warywoda at M* as calculating (dollar weighted) average MERs at 2.13% in 2003. Back out GST for better comparability and you're down to 2%.

I have two questions.

- Has anybody seen or produced an updated time series for Canada?
- The difference between the US and Canada is almost exactly 1% per annum, which is (not coincidentally IMO) the approximate cost of commissions to advisors. Are Canadians in more need of investment advice than USians?

[DanH]

I have two questions.

- Has anybody seen or produced an updated time series for Canada?

Nope.

- The difference between the US and Canada is almost exactly 1% per annum, which is (not coincidentally IMO) the approximate cost of commissions to advisors. Are Canadians in more need of investment advice than USians?

That real difference is less than that IIRC. Check this spring 2003 article for my admittedly crude examination of U.S. and Canadian MERs.

That said, I think Americans are more aggressive in general - including their investment activities. It's a matter of desire and choice. Many articles report the U.S. mutual fund investor's holding period at about 3 years for stock funds. I can't say that I really know what's behind that figure. But I can tell you that Canadian mutual fund investors hold their equity funds (and most other non-money-market funds) for 6-7 years depending on when you take the measurement.

I'll stop there for fear of taking this thread on a tangent with the first reply.

[Bylo Selhi]

- The difference between the US and Canada is almost exactly 1% per annum, which is (not coincidentally IMO) the approximate cost of commissions to advisors.

It would seem that commissions are included in the weighted average. From M* University [my emphasis]

Expense Ratio. Most fund costs are bundled into the expense ratio, which is listed in a fund's prospectus and annual report as a percentage of assets. For example, if ABC Fund has assets of $200 million and charges $2 million in expenses, it will report an expense ratio of 1%. The expense ratio has several parts. The largest element is usually the management fee, which goes to the fund family overseeing the portfolio. There are also administrative fees, which pay for things such as mailing out all those prospectuses, annual reports, and account statements. The 12b-1 fee can be another large component of the expense ratio. Roughly half of all funds levy these fees. A 12b-1 fee covers a fund's distribution and advertising costs and can be as high as 1% of assets. Those fees that fund families pay to no-transaction-fee networks, which we learned about in Funds 105, often get charged to fund shareholders via 12b-1 fees.

Note "as high as." In Canada most FE and DSC funds incur ~1% for advisor commission but in the US 12b-1s run from 25bp up. I don't know if there's a general consensus like Canada's ~1%, but if there is it's likely 75bp or less per NASD. The SEC on fund fees and 12b-1

[12b-1 fees] include fees paid for marketing and selling fund shares, such as compensating brokers and others who sell fund shares, and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature.

The SEC does not limit the size of 12b-1 fees that funds may pay. But under NASD rules, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75 percent of a fund’s average net assets per year...

[NormR]

In the US, the ICI is out with a report showing that (dollar weighted) full in costs of owning equity funds declined to 1.13% in 2005, with bond funds averaging 0.90%. The decline is attributed more to asset shifts to lower cost funds than to declines in MERs.

Wow, that's very low. Them index funds must be a big factor.

[brucecohen]

Several years ago Investor Economics did a report on Canadian and US MERs. I recall that some of the reasons they cited for the higher
Canadian cost were:

1. Asset mix: Much higher level of foreign content in Canada than in the US

2. More complex and cumbersome regulation

3. Vanguard effect in the US

I don't remember the other factors. IEI also said the average MER for the total US fund universe is heavily skewed by widespread use of money market funds with chequing privileges. This is a legacy from the 1970s when federal law capped the interest banks could pay on savings and chequing accounts but not on MMFs. So every financial organization launched a MMF that functioned as a cheque account.

[DanH]

Several years ago Investor Economics did a report on Canadian and US MERs. I recall that some of the reasons they cited for the higher
Canadian cost were:

1. Asset mix: Much higher level of foreign content in Canada than in the US

That should fall modestly as more expensive clone funds have been terminated.

2. More complex and cumbersome regulation

That's a fair one but could they actually quantify it?

3. Vanguard effect in the US

In Canada, I'm not sure that it could be said that we don't have a similar effect. PH&N is a sizeable company that is now well known among many investors. iShares are very cheap and do lots of marketing (though mostly to advisors).

The big differences, in addition to the above, are GST and the fact that U.S. funds are largely unbundled as Canadian funds were more than a decade ago. For example, U.S. funds either pay no trailers or come in various classes, each paying a different level of trailer fees. All are included in the standard fund databases.

Here, lower fee versions of load funds (i.e. F and I class units) are not included in the standard mutual fund databases. So, the averages are computed with load funds that are bundled with the cost of professional advice.

[AltaRed]

In Canada, I'm not sure that it could be said that we don't have a similar effect. PH&N is a sizeable company that is now well known among many investors. iShares are very cheap and do lots of marketing (though mostly to advisors).

The big differences, in addition to the above, are GST and the fact that U.S. funds are largely unbundled as Canadian funds were more than a decade ago. For example, U.S. funds either pay no trailers or come in various classes, each paying a different level of trailer fees. All are included in the standard fund databases.

Here, lower fee versions of load funds (i.e. F and I class units) are not included in the standard mutual fund databases. So, the averages are computed with load funds that are bundled with the cost of professional advice.

I don't think there is much comparison at all..yet. For the years I was a resident of the USA, the professional people I was in contact with were highly aware of Vanguard, TJRowe and Fidelity (the latter of which has reduced fees and costs to compete). These were household names. Throw on top of that high profile market timing issues and proliferation of ETFs (notwithstanding boutique ETFs are carrying higher costs and a new source of revenue), the US investor is becoming a lot more savy about where their money should go and the big ship is turning.

Few people I talk to in Canada have heard of PH&N and there still is a surprising lack of knowledge about ETFs. Unless my sample of people is not very representative, and that I doubt, Canadians are still pretty much asleep at the wheel. At one time I was able to buy Bissett F Series at E*Trade, but that door got shut. The last time I looked at a sampling of funds (in the last 6 months), F and I series units made up a small component of mutual fund assets. It would be interesting to find out the aggregate portion of mutual fund assets in F and I series.

[Bylo Selhi]

Mutual Funds Fees Around the World [PDF, my emphasis]

Using a new database, we study fees charged by 46,799 mutual funds offered for sale in 18 countries, which together account for about 86% of the world fund industry. We examine management fees, total expense ratios and estimated total shareholding costs (which include load charges). Fees vary substantially from country to country. To explain these differences, we consider fund, sponsor and national characteristics. We generally find that larger funds and fund complexes charge lower fees, as do funds selling cross-nationally, while fees are higher for funds distributed in more countries and funds from so-called offshore locations. Substantial crosscountry differences persist even after controlling for these variables. These remaining differences can be partly explained by a variety of factors, the most robust of which is that countries with stronger investor protection charge lower mutual fund fees....

As we can see, costs vary quite extensively from country to country. For example, using any of the three fee measures, funds domiciled and sold in Canada have considerably higher costs than those sold in its North American neighbor, the U.S. For example, mean management (TER) fees for equity funds are 79 (171) basis points in the U.S. versus 211 (287) basis points in Canada. Similar fee differences are observed for the other investment objectives. Looking at equities, the average management fee in the domicile with the highest fees (Canada) is 2.7 times higher than in the domicile with the lowest average fee (U.S.). The comparable ratio is 3.7 for TERs and 4.3 for TSCs. These results indicate that there are meaningful differences in fees across countries...

The U.S. and Canada are alike in many ways; in the fund industry, both are ‘closed’ fund industries that do not easily permit foreign domiciled funds from selling funds in their countries. However their mutual fund fees differ dramatically. From Table 5 we can see that, after controlling for fund type, fund size, complex size and other variables, the U.S. is among the lowest cost countries (by fund registration) in our sample, and Canada is the single highest fee country by far...

Several key findings emerge. First, while the fund product is similar around the world, the prices charged by funds are very different from place to place. Even neighbors, like the U.S. and Canada, can have remarkably different fees. Second, these differences persist after controlling for various fund characteristics aimed to measure differences in production costs. In fact, we find little evidence of economies of scale manifested in management fees, but larger effects in total expense ratios and total shareholder costs. Third, one cannot ignore cross-border fund sales. In general, foreign competition is associated with lower fund fees...

The tables at the back of the paper are also very illuminating. They show the substantial extent by which Canadian fund fees are higher compared to virtually every other developed country on the planet. But more importantly they show "total shareholder charges (TSC) [which] includes the expense ratio plus an annuitized form of loads" of ~5% which (a) are at least double what every other country charges and (b) make a mockery of retirement on a 4% withdrawal rate using conventional mutual funds. (And yes, "we exclude segregated or seg-funds in Canada.")

[AltaRed]

So until we can get someone else, aka Vanguard, to set up ETFs in Canada and create some more competition along with Barclays, we can expect to continue to get soaked. Course we do have TD efunds, but that hasn't made that big of a dent in the system.

Maybe it is the uneducated masses who have a love/hate relationship with our big banks and their full service brokerage arms, and a seemingly paternal instinct that the 'experts' know best. Quite frankly, I am not sure what it will take to drop average MERs in Canada by 1% or so (allowing for GST, etc).

[beaverlodge]

Quite frankly, I am not sure what it will take to drop average MERs in Canada by 1% or so (allowing for GST, etc).

Eliminate the advisor channel
Wait for the consequences
Do not return to the advisor channel
Then proceed accordingly

[AltaRed]

Quite frankly, I am not sure what it will take to drop average MERs in Canada by 1% or so (allowing for GST, etc).

Eliminate the advisor channel
Wait for the consequences
Do not return to the advisor channel
Then proceed accordingly

Yeah, fine for us educated minority, but how to get the masses to flee the advisor channel in the first place?

[Bylo Selhi]

Eliminate the advisor channel

I wasn't aware that the rest of the developed world had managed to eliminate the advisor channel. Are you sure that's why MERs are so much lower everywhere else?

Wait for the consequences

What consequences would those be? Are they being experienced by the rest of the developed world that has apparently eschewed the advisor channel? If not, why not?

Perhaps we all have something to learn from the rest of the developed world that would allow investors to benefit from 1% MERs without the calamity that you apparently anticipate would ensue.

[NormR]

So until we can get someone else, aka Vanguard, to set up ETFs in Canada and create some more competition along with Barclays, we can expect to continue to get soaked. Course we do have TD efunds, but that hasn't made that big of a dent in the system.

Maybe it is the uneducated masses who have a love/hate relationship with our big banks and their full service brokerage arms, and a seemingly paternal instinct that the 'experts' know best. Quite frankly, I am not sure what it will take to drop average MERs in Canada by 1% or so (allowing for GST, etc).

I note that several low-fee fund families have set up shop in Canada only to fail.

[AltaRed]

I note that several low-fee fund families have set up shop in Canada only to fail.

Thus the result of the uneducated masses that either cannot or choose not to think for themselves...and merely react to their full service broker's recommendations or react to who is selling the most advertising. A sad reflection of Canadian financial acumen.

[The Wealthy Boomer]

The GST cut should shave MERs a few beeps.

[beaverlodge]

Yeah, fine for us educated minority, but how to get the masses to flee the advisor channel in the first place?

Approximately 95% uneducated
Approximately 5% educated
Plug in your own numbers. They won't be far off.
The uneducated cannot flee.

I wasn't aware that the rest of the developed world had managed to eliminate the advisor channel. Are you sure that's why MERs are so much lower everywhere else?

It would be a big start and very satisfying to those who do not like the advisor component.

What consequences would those be? Are they being experienced by the rest of the developed world that has apparently eschewed the advisor channel? If not, why not?

Who knows? I suspect it would be one hell of a dent on the financial pillars in Canada. I would speculate many fewer advisors, much deeper bank penetration on wealth management and an even more uninformed public. In its own way it might even bring about Federal Regulation.

[DanH]

Survey shows we pay twice U.S. rates

I had hoped to get a little more coverage in that article - not for my ego but to set the record straight on this working paper. My submission to the paper's authors essentially makes two points.

1. The formula they use to compute Total Shareholder Costs (TSC) is overstated because it includes an annualized front end load + an annualized back end load. Hate DSC all you like but no investor I know of is capable of incurring a front and back end load on the same purchase.

2. The comparison of Canadian fund fees to U.S. funds (and to other countries) is flawed because Canadian funds include compensation to distributors while U.S. funds often do not. The comparison they make in the paper (p 21) is between U.S. and Canadian versions of Fidelity Japan. They state the ER difference is 167 basis points. But it's actually about 55 basis points when controlling for things like payments to distributors (which the authors acknowledge they have no data on) and GST (i.e. to isolate investment and regulatory expenses only).

So, not such a big story after all. And what's most striking is how the DIY crowd here just accepts their conclusions without any apparent scrutiny because it sort of supports "the cause" so to speak. Yet, when something is posted that goes against the conventional thinking here, posters begin picking apart the data and methodology. I find it all rather interesting.

As soon as I saw this I suspected it was wrong. But I guess you only find that out if you bother to read the paper and not accept it at face value.

[Shakespeare]

And what's most striking is how the DIY crowd here just accepts their conclusions without any apparent scrutiny because it sort of supports "the cause" so to speak.

Maybe some of us are just tired of hearing one more iteration of the same arguments, Dan. Not commenting on the paper does not necessarily mean I(we) unreservedly accept it. Hmmm?

[Bylo Selhi]

Survey shows we pay twice U.S. rates I had hoped to get a little more coverage in that article

That may be because it's unavailable to the great unwashed. Where's the "free" version?

So, not such a big story after all.

Well even if one accepts your two points, it's still the case that Canadian mutual funds are the most expensive, albeit by a narrower margin. Is that explained only by our plethora of provincial regulators, bilingualism (other countries like Switzerland and Belgium are also multilingual), and that damned GST (other countries have VATs that make our GST appear trivial)?

And what do you make of their contention that "countries with stronger investor protection charge lower mutual fund fees"?

[beaverlodge]

One can compare countries all one wants but comparisons on all issues financially and otherwise have to be discounted because every country is different.

That is the nature of countries.

[The Wealthy Boomer]

Dan, the space constraints of an 800-word column preclude all sorts of subleties and context. The first draft was past 1,000 and the first thing that had to be jettisoned was a para on F class funds and the fact DIYers who don't need advice can't buy them without paying for advice at another level. The version I submitted did include the Fidelity Japan example on both sides of the border but was apparently edited out for space reasons.

But I think the gist of what you said was in there and it was picked up on the inside-turn headline: "An analyst says U.S. comparison is distorted."

My wife is a typical investor and would-be "sucker" on fees were it not for her unique circumstances and being an indirect beneficiary of this very forum. She noticed that while IFIC couldn't be bothered to try to refute the study that Dan in effect did the job for them. So kudoes to Dan.

The other telling quote was the one by Jim Rogers about how the banks could have helped drive over all costs down but chose not to.

P.S. More on this in today's blog: see www.nationalpost.com/chevreau

[NormR]

The other telling quote was the one by Jim Rogers about how the banks could have helped drive over all costs down but chose not to.

The banks are smart and don't want to ruin a good business. I'm reminded of ...

A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business by Charles Munger

Over the years, we've tried to figure out why the competition in some markets gets sort of rational from the investor's point of view so that the shareholders do well, and in other markets, there's destructive competition that destroys shareholder wealth.

If it's a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world—safe travel, greater experience, time with your loved ones, you name it. Yet, the net amount of money that's been made by the shareholders of airlines since Kitty Hawk, is now a negative figure—a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business.

Yet, in other fields—like cereals, for example—almost all the big boys make out. If you're some kind of a medium grade cereal maker, you might make 15% on your capital. And if you're really good, you might make 40%. But why are cereals so profitable—despite the fact that it looks to me like they're competing like crazy with promotions, coupons and everything else? I don't fully understand it.

Obviously, there's a brand identity factor in cereals that doesn't exist in airlines. That must be the main factor that accounts for it.

And maybe the cereal makers by and large have learned to be less crazy about fighting for market share—because if you get even one person who's hell-bent on gaining market share.... For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I'd ruin Kellogg in the process. But I think I could do it.

In some businesses, the participants behave like a demented Kellogg. In other businesses, they don't. Unfortunately, I do not have a perfect model for predicting how that's going to happen.

For example, if you look around at bottler markets, you'll find many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises. That must get down to the peculiarities of individual adjustment to market capitalism. I think you'd have to know the people involved to fully understand what was happening.

[Bylo Selhi]

the ICI in Washington has noticed fees on U.S. funds have dropped by 50% since 1980.

Well that too needs to be examined critically, e.g.

• Memo Re: Investment Company Institute Releases on "Total Shareholder Costs of Mutual Funds"

A recent ICI Study (Total Shareholder Costs of Mutual Funds: An Update; September 2002) updates other studies it has provided over the past four years, purporting to show the costs of mutual fund ownership. Once again, the study relies on the sales-weighted costs of funds, rather than the more relevant asset-weighted data. Once again, it fails to report the continuing rise in fund expense ratios, or even present those expense ratios for analysis. Once again, it ignores the impact of low-cost index and institutional funds. Once again, it relies on sales charge calculations that appear to significantly understate this component of annual costs. And once again, it ignores three extremely large components of fund shareholder costs (financial adviser fees, portfolio turnover costs, and out-of-pocket fees).

• "Gentlemen … to Save Our Business From Ruin, We Must Reduce Expenses"

Yet industry expenses are not only not being reduced, they are soaring. Since 1980 the annual expense ratio of the average equity fund has risen by more than 40%—from 1.10% to 1.57% of fund assets. It has been documented, well, everywhere. But, the industry takes the position that the cost of fund ownership is declining. Or that's what the industry's Investment Company Institute says. What it means is that, according to its rather tortured and convoluted methodology, the cost of purchasing equity funds has, in fact, declined, from 2.25% annually in 1980 to 1.49% in 1997. The industry reaches this conclusion by including sales charges plus expense ratios, and then weighting the results by the sales volume of each fund each year. High cost funds that don't sell don't count. Virtually ignored in the ICI methodology, the managers of funds that investors shun nonetheless prosper, even as their shareholders suffer.

• Mutual Fund Industry Practices and their Effect on Individual Investors

[yielder]

which would be here. Ain't permalinks neat.

[DanH]

Maybe some of us are just tired of hearing one more iteration of the same arguments, Dan. Not commenting on the paper does not necessarily mean I(we) unreservedly accept it. Hmmm?

Fair enough. It was just my observation. It's just that when the paper was posted, what was emphasized was that we were by far the most costly country. There's implied support for the conclusions. (I swear, smelly did not come to my office, tie me up, and take over my keyboard.)

In other words, why post it and highlight it at all when it's a draft paper with at least one incomplete formula and at least one distorted comparison?

Well even if one accepts your two points, it's still the case that Canadian mutual funds are the most expensive, albeit by a narrower margin.

Says who? The paper stated that the U.S. is cheapest on the planet. And I confirmed that Canada is more expensive than the U.S. With no information on payments to distributors for ANY of the countries studied (which the authors acknowledge, to their credit), how can you be sure exactly where Canada stands, except in relation to the cheapest country in the world? This is a working paper - i.e. research that is in draft form and not yet complete.

Is that explained only by our plethora of provincial regulators, bilingualism (other countries like Switzerland and Belgium are also multilingual), and that damned GST (other countries have VATs that make our GST appear trivial)?

I don't know the regulatory environment in those other countries but I know we're the only G7 country without a national securities regulator. So, it's possible that our regulations are more costly. I know that GST is a factor. I can't explain it all but in the Canada-U.S. comparison, it's payments to distributors that makes up the biggest portion of the gap.

The paper includes such payments in Canadian fund MERs because they're built in. They're excluded from the U.S. fees because they're charged separately.

And what do you make of their contention that "countries with stronger investor protection charge lower mutual fund fees"?

I don't quite understand how that's possible. The point they do make - and that makes more sense to me - is that more competition results in lower fees.

Dan, the space constraints of an 800-word column preclude all sorts of subleties and context.

I know. I wasn't being critical of you. I just wanted to provide additional information that did not get into the article. And I was a bit frustrated at the title your editor chose for the piece since it's false.

She noticed that while IFIC couldn't be bothered to try to refute the study that Dan in effect did the job for them. So kudoes to Dan.

Thank you. Maybe I should send IFIC an invoice

But my motivation is not to protect the industry or get publicity. Rather it is to set the record straight when nobody else seemed willing to do it.