It's now pretty much official: Canadians pay the world's highest mutual fund fees. A draft paper released this past summer confirmed that Canada is No. 1 by a huge margin. The paper was written by three academics—Ajay Khorana of Georgia Institute of Technology; Henri Servaes, from London Business School; and Peter Tu-fano of Harvard Business School—and it's one of the most exhaustive studies ever done on global mutual fund fees.
The trio examined 46,799 funds offered in 18 countries. Researchers calculated an annual "total shareholder cost" (TSC) for each fund by adding the yearly fees charged by the fund (known in Canada as the management expense ratio, or MER) and any one-time commission paid to the seller of the fund. The commission was divided by an assumed holding period of five years.
The average TSC for funds sold in Canada was 4.7%, far ahead of second-ranked Ireland, at 2.7%, and the overall average of 1.9%. Some Canadian fund analysts questioned the percentages in the study, but even they agreed that Canadian fees are relatively high. You can almost see the authors of the study raising their eyebrows at our fees in a section of the paper titled "A tale of two North American neighbours." The U.S. and Canada have similar rules governing their fund industries, yet the average TSC for funds sold in the U.S. is just 1.7%. What gives?
There are more than 5,000 funds to choose from in Canada, and investors can look up details on fees in fund prospectuses and on websites like Morningstar and Globefund. Economic theory would tell you that competition should lower MERs as investors shop around.
The thing is, mutual funds in Canada aren't bought; they're sold. Most investors don't have time to do detailed research, so they rely on an adviser, a financial planner, an insurance agent or a sales rep at a bank to help them.
A typical large Canadian equity fund charges an MER of roughly 2.5%. Some of that goes to the fund manager to pick stocks, and other portions cover things like office expenses and the manager's trading costs. But a big portion—say 0.75 to 1.5 percentage points—typically goes to the firm that sold the fund. And roughly half of that could go to the sales rep. In theory, this so-called trail commission pays the adviser for ongoing service to the client. But it's also an annual reward for keeping the client in the fund.
When you know how funds are sold, you can understand why fees are high. The normal economic behaviour of an intermediary is to maximize return—the larger the payment from a producer, the more likely I am to sell the product.
Forthright people in Canada's mutual fund industry will tell you that competition for a relatively small number of top-performing advisers and fund managers is the reason for higher fees. The best advisers have lots of well-heeled clients. Do advisers steer clients to lower-commission funds? Why would they, or should they?
Even to reach the millions of small mutual fund investors, the distribution channel isn't very wide. The study notes that Canada's fund industry is small in total dollar terms, "and is dominated by bank distribution in a relatively concentrated banking sector." The Big Five banks have 84% of all banking assets, they own the largest investment dealers and they have their own house-brand mutual funds.
Crunching data from all 18 countries, the authors found that the higher the concentration of banking assets in a country, the higher the fund management fees. This makes sense. If the competition is for talent to distribute the product, not for the product itself, why not lure the best with a bigger cut of the fee?
Investors should ask if high-fee funds generate higher returns or provide better service. There are lower-fee funds. Exchange-traded funds based on market indexes have MERs that, in many cases, are less than half those of comparable mutual funds. An extra $1,000 or so in annual returns on a $100,000 investment adds up.
There are other ways for individual investors to profit from the Canadian fee anomaly. The AGF and CI fund families both have publicly traded securities. CI is an income trust that pays the lion's share of its cash flow back to trust holders.
I've never heard complaints from investors who watch the "expensive" fund industry from their investment-quarterback armchairs, monitoring their shares in the Big Five banks and other financial service firms. As long as the industry remains concentrated and unwilling to compete on the basis of price, you might sleep better by simply joining the high-fee club as one of these investors, rather than trying to figure it all out.
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