A May, 2006 unpublished research report, entitled Mutual Fund Fees Around the World states that “Canada is the single highest fee country by far ”. The study examined 46,799 mutual funds in 18 countries, accounting for 86% of the global fund industry. A 2003 study, Expense Ratios of North American Mutual Funds, concluded that Canadian expense ratios are 50 % higher than in the U.S. and that economies of scale and lack of competition account for only 24 % of the MER discrepancy.

A 2003 study by Morningstar Canada concluded that despite tremendous industry growth, investors are generally not receiving the benefits of economies of scale. The estimated average MER for all funds went up from 2.02% in 1995 to a historical high of 2.62% as of April 30, 2003 and 78% of funds increased their MER between 1998 and 2002 even as assets increased .A number of recent media articles have once again put Canadian fund fees under the spotlight and on the spot.

IFIC, industry participants and others are rightfully picking away at imperfections in the research studies. Some are challenging the assumptions such as average hold. period. while others suspect some fees have been double counted. While Seg funds were not included in the study, more expensive RSP clone funds may have been. When the DSC schedule periods end, if the units are not automatically shifted to a lower MER series, fees will be excessive and show up in academic studies as such. Few firms in fact differentiate DSC MER’s from FEL MER’s.

No doubt issues of the GST, bilingual documentation and having to deal with 13 provincial regulators will also be raised as partial explanations for Canada’s higher fees. IFIC, as the fund industry’s lobbyist, has committed to providing a response to the studies and adverse publicity by the end of September.

While there is no doubt that fund MER’s, along with taxes and asset allocation are the primary determinants of portfolio performance, there are other issues surrounding fees that need airing.

MER’s are in fact only one of several fees that fund investors pay. Recently the CSA has required fund companies to disclose Transaction Expense Ratios that highlight the costs associated with trading activity. Other fees such as wrap fees, asset allocation service fees and systematic withdrawal plan fees, where applicable, are not counted in the debate but they are real and not insignificant. Research studies suggest that wrap fees are on the increase in Canada which add to the bill investors pay. Additionally, expensive structured products like PPN’s escape the scrutiny of researchers because they are not, strictly speaking, securities. Although mutual funds are at the core of many of these exceptionally high fee products, they are excluded by analysts who concentrate on stand-alone mutual funds. Segregated funds, technically an insurance product, use mutual funds as their underlying investment have MER’s some 50 bps above traditional mutual funds.

In other words, when a broader view is taken of fees, Canadians appear to be getting hosed at every turn.

One of the key issues surrounding mutual fund fees is their complexity and opaqueness. In the United States for instance, fund companies must disclose the amount of fees paid for distribution - the 12b-1 fee. No such requirement in exists in Canada so investors are often flying half-blind when making fund purchase decisions.

If IFIC and it’s influential members only response is to critique the research studies, countering the claim that Canada has the world’s most expensive fees, they may open up a can of worms. Because commission disclosures are opaque, many fund investors think “advice” is “free” and do not understand that it could be conflicted. In a well-publicized case, a fund firm obtained a regulatory exemption allowing them to rebate early redemption penalties of low MER/low trailer commission funds and replace them with significantly higher MER in-house proprietary funds. Investor advocates have pointed out for years that trailer commissions are paid to discount brokers who offer no advice at all. Fund investors end up paying the price for all this gamesmanship, most of which is not captured by the academic studies.

Fund churning, as noted in the classic 1998 Stromberg report Investment Funds in Canada and Investor Protection: Strategies for the Millennium is indirectly promoted by the convoluted embedded commission fee structure we have here in Canada. It should come as no surprise that the 6-7 year average hold periods correlate well with the DSC early redemption fee schedule. Trailer commissions paid to advisers are embedded in the MER. They range from 0.5% to as high as 1.5% for equity funds. The trailer is going to affect their “advice” so advisers will naturally attempt to direct clients to a fund that pays more, as long as the fund meets their clients’ KYC objectives. Sections 17.8 and 17.9 of the Stromberg Report recommend the need for mutual fund Point-of-Sale documents that provide investor educating, decision facilitating and fair dealing information. Regulators and industry participants have yet to act. All of these issues result in Canadians paying much higher overall fund fees than they should.

While advisors certainly deserve to be paid for their services, it was the advisor community that successfully blunted E*TRADE Canada’s initiative to make low- cost F class funds available to Do-It-Yourself retail investors. The fund companies buckled, leaving retail investors with severely limited market alternatives for low-fee funds.

The OSC’s Fair Dealing Model [FDM] was supposed to deal with all the selling abuses but the process now seems stalled in the CSA swamp. The core FDM document traced the history of DSC- sold funds, demonstrating how with the passage of time, the needs of investors have been sacrificed to satisfy the needs of distributors/advisers.

Even if all the model assumptions and mathematical issues are resolved concerning the academic studies, there is perhaps a more fundamental question. Are the fund fees in Canada so high that actively- managed funds cannot, in general, match passive benchmarks? A recent report from Standard and Poors Canada reported that the S&P/TSX composite index beat 86 % of actively- managed Canadian equity funds over the past 5 years. The global fund fee study cited above found that Balanced funds in Canada had Total Shareholder Charges (TSC) of a whopping 5.33 % vs. 1.85% globally and 1.70 % in the U.S., the worst differential for any of the fund categories studied.

Numerous academic studies have shown that over the long-term the performance hurdle established by high fees make the vast majority of Canadian issued funds in all categories inferior pre-tax performers relative to passive index funds. For instance for Canadian Bond funds, the 20 year return of a Peer Group of funds returned 7.59 % while the Scotia Capital Universe Total Return Index returned 9.01 % [to July 31, 2006].

A 2002 study by FundMonitor.com Corp., an independent research firm based in Toronto, revealed that in many cases investors who pay a premium fee for their mutual funds, believing it will pay off with better management and richer returns, are dead wrong. The study charted 3,600 mutual funds sold in Canada and measured whether there was any correlation between what investors pay in management expense ratios (MERs) and the performance of their mutual funds. Not only did it turn out that most funds aren’t giving back any more bang for the extra bucks; some fund types actually showed a negative correlation-probably because management fees are deducted before performance is reported and end up cannibalizing whatever bonus returns the fund might have earned. As a result, in most cases Canadian investors are paying more to do worse. Source: K. Libin Big bucks, Big whammy Aug., 2002

While there may indeed be cases where the researchers have overstated Canadian fund fees there are clearly counter-examples where, say U.S. fund companies, have to do more with the smaller fees they have at their disposal. An example would be fund governance. In the period studied, the SEC required U.S. funds to have boards of directors to represent investor interests. No such Canadian requirements existed then (or now) and so U.S. funds were at a cost disadvantage relative to Canadian funds. Another example: In the US, fund companies paid huge fines, individuals were sanctioned, investor restitution imposed and fee reductions implemented in the infamous market timing scandal. In Canada, only five firms were dealt with and all they had to do was return a fraction of the losses incurred to investors via a negotiated settlement. No fines, no disgorgement of profits , no fee reductions, no investigation costs were imposed. Despite a stricter regulatory regime –one that is clearly more onerous than the wrist- slap penalty environment created by Canadian provincial securities regulators - U.S. fund MER’s are lower.

A brewing scandal regarding unauthorized foreign exchange conversions and undisclosed fees in registered accounts may result in a class-action .Yet another example of fees attacking from all sides.

Summation

The Canadian fund industry is clearly more concentrated than in the U.S. Oligopolies tend to be less competitive, so the Canadian fund companies have much greater latitude when setting prices. Twenty years of relatively steady, bullish markets may have helped dull investors’ sensitivities to the impact of mutual fund expenses, but the lower annual returns get, the more investments will be adversely affected. The National Post’s Jonathan Chevreau entitled his August 25 th column Funds charge more because we will pay it. Maybe that’s a clue for investors to sharpen up or face having a retirement nest egg that’s a lot less than they need. An investment analyst calculated that in r ough round numbers, if Canadian mutual fund MERs were at the same level as the rest of the world, Canadian retirement accounts would be 10% greater in ten years, 20% greater in 20 years and 30% greater in 30 years.

We end with a quote from respected investment commentator Andrew Teasdale:

“..As I have said before, allowing individuals to buy mutual funds direct would force advisors to have to compete on what they can add and not on what they can sell. 

One of the problems caused by the absence of competition is that your business process does not need to be efficient.  Your costs can increase without consequence; there is no pressure to innovate, improve efficiency or cut costs.  Indeed, it would appear that there is no real competitive interface between the clients and the institutions.  In Canada most financial institutions do not spend their time competing for clients, they spend their time competing for the brokers who have the clients.  If you can only sell through the salesman, you need the salesmen to sell.

So why has a competitive alternative to the current business framework not been developed?  Why are there not companies actively competing on price and service quality? 

For that we need to look at the barriers to entry and innovation in the Canadian Financial Service’s market place, since there appears to be little or no incentive for any of the current players to step off the gravy train.   This is the real question we should be asking ourselves.  Just what are the barriers to change? What can we do to open up the market place to competition? ”.

That’s a question regulators, politicians, financial services firms and individual investors have to answer. Capitalism works both ways. If the mutual fund industry doesn’t deal with the deep issues, the market will ultimately provide a solution. It may take the form of closed-end funds, index funds, ETF’s, eFunds, access to competitive U.S. mutual funds etc. but there will be a solution. IFIC’s biggest contribution now is not to nitpick the studies but to stimulate the reforms that will make mutual funds a WIN-WIN proposition and a viable, globally competitive industry.