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Fees Upon Fees
12/14/2017 8:16:01 AM
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The Professional Financial Advisor
Toronto-based Financial Advisor John De Goey offers thoughts about fee-based advice, holistic planning and capital markets.



By John De Goey  | Friday, May 21, 2004


 
One of things that can be really insidious if left unchecked, however, are the fees on fees associated with a number of so-called “actively managed” mutual funds.

By now, everyone more or less agrees that “cost matters” when going through the paces of portfolio design. Many experts have come to conclude that the single best indicator of a mutual fund’s expected performance is it’s cost (MER), when expressed as a “reverse indicator”. That means that mutual funds are unlike almost everything else available for purchase today. As a rule, the most expensive ones are generally also the worst. A number of independent resources have demonstrated this repeatedly. It’s quite perverse, really. Imagine a world where Yugos were qualitatively superior to BMWs- precisely because they cost less!

Another thing most people have now come to understand is that stated MERs might actually be significantly lower than actual investor cost. That’s because they don’t take into account the transaction charges incurred when the fund acquires the underlying securities. This has been conservatively estimated to be over 25 basis points (a basis point is 1/100 of 1%). It’s a drag on performance, but never shows up on financial statements or in MER depictions.

One of things that can be really insidious if left unchecked, however, are the fees on fees associated with a number of so-called “actively managed” mutual funds. As many readers would know, there’s a long-standing debate in the financial services industry (please don’t call it a “profession”) about the relative merits of active management (i.e. stock picking) and passive management (i.e. indexing). With mutual funds, as with automobiles, it pays to “look under the hood”.

The generally accepted view within the financial services industry is that if one is going to index at all, it should be done for those parts of the world where capital markets are most “efficient” (i.e. where it is most difficult for stock-pickers to add value). That, in turn means that if there are parts of the world where the stock markets are “inefficient”, one would probably be able to locate a quality active manager who can add some value.

So far, so good. What if that active manager is buying a whole lot of indexes in constructing her actively managed portfolio? Specifically, is it reasonable to pay an active manager a handsome fee for stock picking if that manager simply goes out and buys a whole lot of exchange traded funds (ETFs) to populate the portfolio in question? Fair-minded people can differ in their answers but surely, this might be a source of concern that should be brought to the attention of unitholders.

Let’s use that most inefficient of markets- emerging markets stocks- as an example here. Specifically, let’s compare the strategies used by two of the largest and oldest emerging markets funds around today- C.I. Emerging Markets and Templeton Emerging Markets. Both have a long-term (over ten year) track record that beats the index and the peer group, according to both globefund.com and fundlibrary.com. In terms of long-term performance, there’s really not a lot to choose between the two of them. But take a closer look. Over the past three-year and five-year periods, both funds have lagged their benchmark. Is this a sign of things to come?

The cost of simple access to these sorts of asset classes might explains a lot of why consumers are becoming increasingly fed up with these products. The Templeton fund’s top ten holdings are all individual securities (i.e. companies). The C.I. fund, in contrast, has five of it’s top ten holdings (over 15% of the fund) represented by ETFs. The fund has a total MER of 2.83%. To my surprise, C.I. has confirmed that this cost includes the cost of the underlying ETFs (about 90 bps, on average). That’s still cheap compared to Templeton, where the MER is over 4.00%. If access to Emerging Markets is what you’re looking for, why not just buy the MSCI Emerging Markets iShare at 75 bps (0.75%)? In this case, both the expected and the actual performance numbers come in at the return of the index minus 0.75% in all time horizons. It seems unlikely to me that actively managed funds could consistently beat that if they start each and every year 2% or 3% behind a passive product.

This is all very confusing for many investors because most have come to the general conclusion that any product that costs more must cost more because it is a better product. The truth is that product manufacturers charge what the market will bear. From a manufacturer’s perspective, if someone is prepared to buy a product for a premium price, why not provide that product at that premium price? From a consumer’s perspective, however, the thinking might be a little different. Consumers might be well advised to go to product manufacturers and say “that’s a hefty price for your investment product… do you mind telling me why I should pay it instead buying this cheaper product”?

I mentioned earlier that both C.I. and Templeton funds had outperformed their peers and benchmarks over extended timeframes. Therefore, a clear argument could be made in response to the quasi-rhetorical question posed above. However, that’s only true if the time horizon is ten or more years, when there were a limited number of products available for that part of the world. What consumers need to ask themselves now is whether or not they honestly believe the 10-year track record will continue into the future, especially since the cost of owning the fund would make continued outperformance difficult.

 

John J. De Goey is a Senior Financial Advisor with Assante Capital Management Ltd., member CIPF and an instructor with The Knowledge Bureau. He is also author of “The Professional Financial Advisor”. The views expressed are not necessarily shared by Assante. jdegoey@assante.com

 
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