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On mutual funds, and the leading myths Add to ...

Canada's mutual fund industry has taken many body blows over the past few years. Recent shots have focused on fees and come courtesy of the media, academics and other researchers. Some critiques are valid but others are not. Here are three of the biggest mutual fund myths circulating today.

Myth #1: Canadian mutual funds are the most expensive in the world.

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A few years ago many media outlets rushed to publicize a draft research paper that made this claim. More recently, the fee issue was revived in a report by Morningstar's Chicago office on the experience of mutual fund investors in 16 countries. While Morningstar gave Canada a decent overall rating, it gave Canadian funds the only failing grade on fees.

Both studies correctly conclude that expense ratios (or MERs) charged directly by funds, on average, are high in Canada. But neither attempted to quantify the total costs that fund investors bear - i.e. expense ratios plus fees charged separately for advice. The cost of financial advice is included in the vast majority of Canadian funds' MERs - but they are not in many markets outside of Canada. Nor did these studies attempt to flesh out the many country-specific nuances that could significantly impact global fee comparisons. Still, the claim that Canadian funds are the world's most expensive is often repeated, notwithstanding these methodological gaps. But there's a more relevant chapter to this story.

I counter that the average mutual fund MER holds little practical meaning for investors. Former Globe columnist Duff Young often began speaking engagements by asking: Would you walk across a lake with an average depth of four feet? He was illustrating how average rates of return mask volatility, but the same logic can be extended to fund fees.

The average fee level does not matter if our universe of funds is sufficiently broad to meet the needs of many different investors. For instance, despite this notion that Canada is the costliest fund universe, do-it-yourself investors who want to minimize costs can build diversified portfolios with an MER of less than 0.5 per cent annually using cheap index funds. The MER can be whittled down further, to 0.3 per cent per annum and less, with even cheaper exchange-traded funds.

Many other mutual funds cater to those who choose to engage the services of a financial adviser rather than go it alone. And most of these funds come in two forms - one for advisers paid on commission (i.e. load funds) or a cheaper version for advisers who charge a separate fee for their services (i.e. F series funds). Viewed in this context, the average fee level is insignificant since neither of the above-noted studies examined the breadth of choice available to investors.

Myth #2: Canadians flip their mutual funds too frequently.

A number of articles have estimated that U.S. mutual fund investors hold their non-money-market funds (i.e. long-term funds) for an average of three to four years. Virtually every Canadian article I've read assumes that the same applies here - but it doesn't.

I have studied holding periods for years in the Canadian context. For the 15 years through last summer, Canadian mutual fund investors had held their long-term funds, on average, for about seven years - roughly twice as long as U.S. investors. Still, it's true that mutual fund investors haven't done well in Canada. While poorly timed buying and selling played a role, a potentially larger factor is overdiversification.

Generally, Canadian fund investors hold far too many funds. This is particularly true when examining investors' stakes in Canadian equity funds. Most investors view holding many Canadian funds as diversification. But diversification is only healthy in moderation when buying actively managed funds. Going overboard - i.e. holding more than two Canadian stock funds and more than 10 in total - will doom you to mediocre performance, in my opinion.

Myth #3: It's not the fees that matter but the returns.

This myth is usually trotted out to rebut low-fee advocates. Obviously, a fund's bottom-line performance is what matters most. But this argument ignores the relationship between fees, returns and the gravitational force of time.

A fund's MER is an important consideration when selecting a fund, and it's one of my many fund selection criteria. The importance of a fund's MER, however, depends on the type of fund. Generally, the MER is more important with more conservative funds, where there is a relatively narrow spread between the best and worst performers. For example, picking investment-grade bond funds that will outperform in the future is a snap. Simply sorting by MER gets you most of the way toward short-listing bond funds. As you move across the spectrum to riskier balanced and stock funds, the relationship between fees and returns weakens.

With stock funds, the impact of fees is rarely seen until the period of evaluation approaches 10 years. Over shorter periods, it's unlikely that you'll notice any link between fees and performance. But over longer time periods, top performers usually sport below-average fees, with few exceptions.

Dan Hallett, CFA, CFP is the president of Dan Hallett & Associates Inc., a Windsor, Ont.-based investment research firm.

dha@danhallett.com

 

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