Proper recognition must be paid to the mutual fund industry for its role in fostering financial illiteracy in Canada.
Here's an odd thing about the companies that look after more than $640-billion in investments for people who choose not to manage their own money. They're good at the little things that explain what they do, but they blow the big stuff. That's why the fund industry's customers include some of the country's most financially illiterate people.
Questions flow into this column all the time. One of the most common these days: Do mutual fund returns reflect the impact of fees, or do I have to subtract fees from published returns to know how much I'm really making? (Published fund returns are virtually always shown on an after-fee basis.)
Frankly, it's a step forward for this question to be asked because it reflects the awareness that there are fees associated with owning mutual funds. But what's up with customers of such a ubiquitous product as mutual funds not knowing something as basic as how fees affect returns?
A financial literacy task force reported to the federal government last month on ways to make people smarter about money. The Personal Finance column now chips in with five suggestions for the people selling the investment of the masses, mutual funds, to promote smarter consumption of its products.
1. Be more clear about fund returns.
Fund companies provide a valuable service to investors, and it's right and proper that they charge enough to make a profit. The problem is that fund fees have been disconnected from returns.
Ideally, fund companies would express returns like this: "Our one-year return is 8 per cent after fees of 2 per cent were taken off the top." Yes, there will be times when investors will see they have lost money and still paid fees. If the fund industry's not comfortable with that, how about moving to a pay-for-performance model - generous fees in good times, zero fees in bad?
2. Cut the nonsense with management fees.
Almost all the costs of owning a mutual fund are built into something called the management expense ratio (MER), a measure of fund expenses as a percentage of assets in a fund. The biggest of these cost components is a management fee, which covers such things as paying managers, keeping offices running and compensating investment advisers.
If you're an investor, you care about the MER, not the management fee. It's like when you buy tomato soup: You want to know how much a can of soup costs, not the price of tomatoes. Unfortunately, too many fund companies (and some exchange-traded fund companies) like to publish management fees as if they're relevant to investors. The cynical take is that investors will confuse the management fee with the management expense ratio and think they're paying less than they are.
3. Remind everyone that advisers are getting paid, too.
Let's say an investor named Jane owns an equity fund with an MER of 2.25 per cent. A full percentage point of that is paid by Jane's fund company to her investment adviser each year as compensation for client service. In fund industry jargon, these payments are called trailing commissions.
Advisers are the mutual fund industry's sales force, so the long-standing practice of burying the cost of advice in fund fees is understandable. Now, it's time to remind investors that when they buy most mutual funds, they're paying for advice. This will help put mutual fund fees in better context, and it will prod investors to consider the actual advice their fees are buying.
4. Remind investors that MERs aren't the whole story.
One of the little things the fund industry does well is produce semi-annual updates on fund performance. Way at the back, in a section with the seductive title Ratios And Supplemental Data, are data on something called the trading expense ratio, or TER.
The TER measures a fund's stock-trading commissions as a percentage of assets. Add it to the MER and you've got the total cost of owning a fund. How about bringing the TER out of obscurity every so often, standing it up next to the MER and telling investors what the total, all-in cost of owning a fund is?
5. Be accountable on fees.
In those twice-a-year reports to investors, fund companies should include a formal discussion of fees. If fees are going down, it's a perfect opportunity to explain the good news to clients. If they're rising, here's a chance for some adult-to-adult straight talk.
Being accountable for what you charge customers is a basic fact of doing business, except in the fund industry. No wonder its customers are clueless about fees.
Let's use the imaginary XYZ Equity Fund to show how fees affect the returns of actual mutual funds.
Management expense ratio (MER)
2.25 per cent
1.) Management fee: covers fees paid to managers, administrative expenses, compensation to advisers
2.) Operating expenses: covers legal costs, record keeping
Trading expense ratio (TER)
0.2 per cent
TER covers the brokerage commissions a fund pays for trading securities
Total cost of owning the fund
2.45 per cent
2010 actual return of investments in the fund, before fees
15 per cent
2010 net return, publicly disclosed to investors, websites such as Globeinvestor.com
12.55 per cent
Note: published fund returns are virtually always shown on an after-fee basis