THE TRUE COST OF OWNING FUNDS

In a period where technology investments have delivered astronomical returns, many beneficiaries of these gains would ask why someone like me bothers to focus on fees. Well, the fact is that returns going forward have a dimmer future as compared to the last twenty years. So my view going forward is that we'll have substantially lower investment returns from securities in general - especially the hot technology stocks as a group. Don't get me wrong, I think technology will change the way everybody does business to some degree. But even great companies can be considered risky or speculative if you pay too high a price. If you buy my hypothesis of lower future returns, you've got to agree that costs will be a more important factor than they've been in recent years.

Most of us judge a fund's cost by its stated MER (that's management expense ratio). However, a fund's MER excludes costs that are indirectly borne by fund investors (i.e. they are paid by the fund) but not disclosed in the MER. Realistically, this makes the true cost of owning funds higher than we thought. I should be really clear though, that what you see in returns is net of all such fees (implicit and explicit).

What's in the MER?

Here's the textbook definition (from a prospectus): MER is the total of all fees and operating expenses (excluding brokerage, taxes and interest) paid by a Fund expressed as a percentage of its average net assets. Typically ranging from 0.20% to 0.40% annually, operating expenses include things like accounting, administration, audit, legal, and custodial costs. Management fees (paid to team of stock pickers) are pretty straightforward and typically range from 1.5% to 2.5%.

Brokerage Fees

Brokerage fees are incurred whenever a fund manager buys or sells a stock. The more often a manager trades, the larger the impact of these costs. The impact of trading is tough to generalize since each firm has different economies and trading frequency. Trading frequency is measured by calculating a fund's turnover rate - the portion of a total fund's assets traded in a year. So a turnover rate of 120% means that the total value of stocks bought or sold was equal to 1.2 times the average assets of the fund. Another way to interpret turnover is to invert it into a holding period. A 120% turnover rate translates into an average holding period of 0.83 years or 304 days (1/1.2 x 365). For example, CIBC International Small Companies (run by Talvest and subadvised by Pictet International) is a good example. It reported turnover rates well above average in 1998 and in 1999 incurring trading costs equating to 1.17% and 1.10% of fund assets, respectively. Investors haven't noticed this because the fund has hit a home run by holding lots of technology stocks (namely in Japan) and produced big returns. But over time, that pace simply can't continue and the trading costs will weigh more heavily on the fund's bottom line.

So why aren't brokerage fees included in the MER? Well, brokerage fees are considered capital costs. As such, they are "capitalized" rather than expensed. That means they're simply included in the cost of securities purchased. Suppose a fund buys 100 shares of a stock at $10 per share and that it costs you a total of $40 in commission. Rather than show the $40 as an expense, it shows up in the total cost of the shares. So the 100 shares would go on the fund's books as costing $1,040 ($1,000 + $40).

Taxes

That's right, you pay taxes (GST) on mutual fund management fees and administration costs. GST on administrative costs are often included in the MER but not tax on the management fee - usually the largest single expense. The impact here can be generalized by taking the management fee (not the entire MER) and adding 7% for GST. So a fund with a management fee of 2% would have 14 basis points added to its total MER (i.e. 0.02 x 0.07 = 0.0014 or 0.14%).

The Bottom Line

With all of these extra costs that aren't normally disclosed, what is the real cost of owning funds and how much more is it than the stated MER? The table below illustrates this point for a few selected funds. Note: The illustration that follows is not meant to single out any one fund. Since this type of information is not readily available and must be calculated manually, specific funds were chosen to illustrate both extremes of the cost impact.

For the year ended Dec 31, 1999	AIC Advantage	Altamira Capital Growth Fund Ltd.	CIBC Int'l Small Co.s	Trimark Fund
Published MER	2.26%	2.00%	2.50%	1.52%
Trading Costs	0.01%	2.14%	1.10%	0.10%
GST	0.14%	0.14%	0.18%	0.10%
Implied MER*	2.42%	4.28%	3.78%	1.72%
Turnover**	23.3%***	844.9%	181.1%	42.9%

Notes:
*Implied MER may differ from the total of the items listed due to rounding.
**Turnover was calculated by taking the average of purchases and proceeds of sale, and dividing by weighted average net assets. Of those fund companies that do disclose turnover in their annual reports, all calculate it based on the lesser of purchases and proceeds of sale.
***This turnover rate includes the crystallizing of gains (and repurchase of securities) to take advantage of the capital gains refunding mechanism. Turnover before this crystallization is estimated at about 7% for the year.

What Does This Tell Us?

The difference between published MERs and implied MERs is due mainly to transaction costs, which are a factor of a fund's turnover rate. Hence, we can take a couple of generalizations:

1. Buy-and-hold managers, as a group, have an edge over their high turnover counterparts. The increased cost puts the heavy trader at more risk of underperforming. High turnover is sometimes unavoidable. Specialty funds that focus on specific countries, regions, or sectors will almost always have high turnover. That's a natural by-product of the narrow mandates of those funds.

2. Larger companies have a cost edge over their smaller counterparts. The large amounts of money managed by bigger firms allows them to negotiate lower trading costs, thereby resulting in a less severe impact when trading securities. Even if a fund is small, a firm may have a substantial institutional business in order to negotiate low trading costs.

3. These issues are not restricted to mutual funds. They apply to all types of pooled investment funds and wraps that use investment funds. While wraps and pooled funds may invoice you directly for management fees (plus GST) directly, trading costs often remain a hidden cost.

Where To Get This Information

As mentioned above, this information not easy to find. Brokerage commissions are always disclosed in the notes to the financial statements of a fund. However, more and more companies are disclosing portfolio turnover rates. Turnover rates are usually found in annual or semi-annual reports in the "Statement of Financial Highlights" towards the bottom in a section titled "Ratios/Supplemental Data". You could try calling a fund company for the information but you're not likely to get somebody on the phone who is able to give you the information. Of course it wouldn't hurt to let fund companies know that you'd like to see the figure disclosed. (Though annual reports can be searched at http://www.sedar.com/search/search_form_mf.htm).

If you can get a hold of the portfolio turnover rate, you can estimate the brokerage commissions by using a rule of thumb. Take the turnover rate and multiply it by 0.40. The result should be the approximate trading costs expressed as a percentage of fund assets. For example, a fund with a turnover of 80% would incur trading costs of about 0.32% (0.8 x 0.4). For larger companies, like Trimark, that number would be substantially lower (about half) but for small companies it might be about 50% higher.

Conclusion

Should you stop buying mutual funds and avoid all high turnover funds? I don't think so. Mutual funds remain a great way to build and manage wealth and there are some great funds that do trade very actively. That said, it's important for investors to know what they're buying and the costs involved. There's nothing wrong with having some high turnover funds, but as the saying goes, everything in moderation. Comparing funds strictly on the basis of MERs may actually be misleading if the two funds have very different styles. Building your portfolio's core by choosing funds with reasonable MERs and a buy-and-hold philosophy will help build a solid foundation and keep your overall portfolio fees in check.

Dan Hallett, B.Comm., CFP is Senior Investment Analyst with Sterling Mutuals Inc., 880 Ouellette Ave. 9th Floor, Windsor Ontario, N9A 1C7. He can be reached by e-mail at dhallett@sterlingmutuals.com or by phone at (519) 256-8999.