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Ontario Premier Dalton McGuinty (CHRIS YOUNG)
Ontario Premier Dalton McGuinty (CHRIS YOUNG)

Derek DeCloet

A bit rich: The fundco case for HST exemption Add to ...

Ontario Premier Dalton McGuinty, a man who is to charisma what Wonder Bread is to fine cuisine, suddenly has Bay Street's attention.

The mutual fund industry hates his government's new harmonized sales tax, which will raise the sales tax on funds to 13 per cent from 5 per cent. Ever since it was unveiled in the province's March budget, the fund sellers have whined, pleaded, pounded their fists and demanded an exemption. This week, Mr. McGuinty opened the door, just a crack, to doing so.

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So the fundcos are hanging on the Premier's next words, full of hope. They're likely to be disappointed. Why? Because in the final analysis, the Premier will realize that his tax doesn't commit any more harm to middle-class investors than the fund companies already do themselves.

At the heart of the fund industry's lobbying effort is one of the simplest concepts in personal finance: the magic of compound interest. Take the example of a 45-year-old investor who puts $20,000 into a mutual fund in an RRSP. This hypothetical fund comes with very high fees (2.75 per cent) but nevertheless churns out some excellent gains; by the time the investor is 85, he has a nifty nest egg of about $835,500.

Here's the punchline: If not for the provincial government imposing its dastardly HST, that number would be $70,000 higher. "We would hope that the government would not want to take 350 per cent of your initial investment if they truly understood the consequence of this tax," writes Patrick Farmer, chief executive officer of EdgePoint Wealth Management and the author of this example.

Well, when you put it that way, of course not. A 350 per cent tax? Ridiculous! Man the barricades and begin the revolt! But the fund industry might want to think twice before it spends too much energy advancing this particular argument - because the same math that applies to a little bit of sales tax applies on a much larger scale to mutual fund fees.

Let's use EdgePoint's case study of the middle-aged investor with $20,000. Doesn't a 2.75 per cent fee seem a bit much for a plain-vanilla mutual fund - even a good one? Two per cent ought to be enough to pay for the managers, their travel expenses and all the other costs of running money, with a healthy profit margin. That extra 0.75 per cent in fees, compounded over four decades, amounts to $282,713 in lost wealth - or 1,314 per cent of the original investment.

All together now: We would hope that mutual fund companies would not want to take 1,314 per cent of your initial investment if they truly understood the consequence of these fees.

The real question is why an investment manager's services ought to be tax-exempt, when a lawyer's or accountant's or barber's services are not. Fund company executives will tell you that a tax on their products is a disincentive for individuals to save.

We can all agree that saving is good and necessary, and that governments should encourage it. But there are a lot of ways to save other than buying a mutual fund. And in any event, it's an argument that ignores the larger issue of why sales taxes exist in the first place.

All taxes are a disincentive to do something. High marginal income tax rates act as a penalty for those who work harder to earn more. Taxes on capital gains and dividends carry their own costs and disincentives to saving and investing. That's why most credible economists favour value-added taxes such as the GST or HST; they snag everyone but at least they hit big spenders the hardest. On balance, the HST is probably a modest incentive to increase savings.

It's understandable, though, that the mutual fund machine is kicking up a fuss. Few industries are as poorly positioned to pass on a new tax to their customers as this one; after the crash, most fund companies are already struggling to explain their value for money. The average Canadian equity fund has returned about 6.2 per cent annually over the past 20 years after fees, according to Globeinvestor.com. The S&P/TSX composite has earned 7.6 per cent, including dividends. (Both numbers are as of the end of August.) Do the math, and fund fees and expenses are eating up nearly 20 per cent of returns. And some customers know it.

That's one reason (though by far not the only one) why so many of the old-line mutual fund sellers are struggling so. Invesco Trimark, Franklin Templeton, Brandes Investment Partners have all lost roughly one-fifth of their Canadian fund assets in the past year. After years of redemptions, Michael Lee-Chin finally threw in the towel and sold AIC.

Lately, the fundcos' outlook has improved because the markets are so hot. But the presence now of so many cheaper alternatives - hundreds of exchange-traded funds - will make conventional mutual funds more difficult to sell than ever. So difficult that, without an exemption, some fund companies will be forced to eat the new HST, rather than pass it on to investors. Is that what's really bugging them?

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