Are mutual
fund fees on the rise?
This week,
fund researcher Morningstar Canada released the results of a study aimed at
quantifying the trend in mutual fund management expense ratios (MERs) over the
past eight years. The trend they found was a rising one. Not surprisingly, the
study has attracted industry criticism, but I think everybody’s making too much
of this study.
Morningstar
quantitative analyst, Mark Warywoda, authored this study entitled Why
Canadians pay for fund management. The industry is up in arms because of
the overall conclusion that average fund MER has increased from 2.02 percent in
1995 to 2.62 percent today. What many have missed is what the report clearly
states that: a) those figures include
the much more costly segregated funds, and b) the average figures are
calculated using a “simple average”.
To address
these biases, Warywoda excluded seg funds and weighted the MERs of the various
funds according to how much money is held in each (i.e. so that a fund with
lots of investor money will be more heavily weighted than a brand new fund with
no assets).
What he
found was that the dollar weighted MER for just mutual funds rose from 1.93
percent in 1995 to 2.13 percent today. That’s just 1/3rd of the
increase noted previously. But there were factors at work over that eight-year
period which can explain all of the difference in fees.
Many new companies
emerged over the past year eights. Some have been quite successful while others
have not. But the common denominator is that nearly all carry high fees for the
first few years. Also, many engage the services of outside money managers to
run their funds – opting this way instead of creating a new in house management
firm.
These new
trends tend to result in rising costs. Why? New companies need to be
competitive when entering an established market. To be competitive on the
quality of product, they may engage the service of an established, successful
money manager. Such a high quality manager would typically command a much more
significant fee than it would cost a firm to build its own.
But if a
firm is to attract new money, it must offer competitive commissions to
financial advisors who are paid by commissions – which cost money. The cost of
commissions is typically built into the fund MERs. Read this older
article about the challenges Scudder Canada faced in this regard.
Specialty
funds include those with a sector focus or with an emphasis on special
categories of assets. All specialty funds carry higher MERs as compared to
funds covering broader classes of assets. For instance, a gold fund tends to
cost more than a broad Canadian stock fund.
Recall in
1999 and 2000 that new funds were seemingly launched weekly tied in to the
technology boom. But it’s not just tech funds. Thanks to the soaring price of
gold and other commodity prices, there are now more triple the number of gold
and resource funds as compared to eight years ago.
How many
labour sponsored investment funds (LSIFs) and hedge funds do you think were in
existence in 1995? There were fewer such funds than the number of fingers on
both of my hands. Today, there are more than 130 if both categories are counted
with billions of dollars in assets.
The bottom
line is that the proliferation of many types of specialty funds has played a notable
part in pushing up fund MERs because all carry substantially higher fees than
“regular” funds.
Prior to
the year 2000, GST and certain other items (i.e. interest costs) were not
included in the calculation of fund MERs. Such items were always charged (and
hence, factored into the daily unit price and published returns), but they were
simply excluded from the calculation. National
Instrument 81-101 changed the calculation of MERs by including all items on
a fund’s statement of operations.
While the
Morningstar study acknowledges this fact, they make no effort to factor GST
into the older figures. Adding GST to the 1995 average MER of 1.93 percent
would bring the figure to 2.07 percent. That’s still lower than today’s figure,
but increased regulatory costs and other factors noted in this article can
account for all of the difference noted – and then some.
I don’t
have access to the data used in the Morningstar study but I believe they did a
valid job, despite the heavy criticism lobbed at it by industry executives. If
I did a similar study (which I might) comparing dollar-weighted MERs, I would
control for such factors as the specific fund type and MER calculations. And
I’d be willing to bet that the trend wouldn’t be rising at all – but that it
would be flat or declining.
One could
argue that an industry that has increased threefold should be sharing some of
its cost savings with the people whose money has fuelled its growth. And I’d
agree wholeheartedly.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling
Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.