Thursday, 12 July 2012

MERs, Fees, and the Value of Advice

Over the last decade there has been a growing preoccupation with the cost of investing in Canada. Most recently, a study of Global Fund Investor Experience commissioned by Morningstar, released in March 2011, claimed that Canadian investors paid the highest Management Expense Ratios (MERs) of any country represented in the study. For their part, the mutual fund industry has consistently argued that the conclusions of this and previous studies have been based on flawed data, and that Canadians pay fees that are largely the same as other investors around the world once all costs are factored in. Since fees and expenses paid by investors either reduce positive yields in good years or magnify losses in bad, it’s important for all investors to be aware of the true costs of their investments - as well as the alternatives – and the value of working with an advisor.

Management Expense Ratios

In Canada, as elsewhere in the world, all mutual funds have operating expenses that are passed on to customers.  There is the actual amount paid to the mutual fund manager as well as the day to day operating expenses: fund valuation costs, audit and legal fees, costs for mailing prospectuses and annual reports plus – in Canada – HST.  Also included, if applicable, is a trailing commission that is paid to the adviser’s firm that administers the account, and is meant to cover the cost of advice and service to the client. These costs, totaled and divided by the value of the assets under management, form the Management Expense Ratio.

According to the Morningstar study, the median MER of equity funds in Canada was 2.31%, compared to MERs ranging from 1.99% down to less than 1% in the rest of the world. Expense ratios for fixed income funds show a similar pattern, with Canada at 1.31% well ahead of the rest of the world. Fixed income fund holders in the U.S., for example, pay MERs of .75% on average. On the face of it, Canadians are being dramatically overcharged by the mutual fund industry, and since a significant portion of the MER is ascribed to trailer or service fees, advisors are a large part of the problem. Things are not, however, always as they seem.

Defenders of the Canadian mutual fund industry have made some attempt to counter the Morningstar allegations. Industry spokespeople argue that different methods of calculating MERs around the world, including the provision for advisor compensation, differing national tax regimes and different accounting practices have significantly skewed the numbers to the detriment of Canada. The industry argues that once all factors are taken into account, Canadian fund costs are comparable to those elsewhere, and are very competitive with total costs in the United States. Morningstar has responded that methods of calculating MERs are similar around the world, that taxes only account for a fraction of the difference, and compensation to advisors included in MERs has been taken into consideration. Thus far, media commentators have generally sided with Morningstar, and have tended to report the study’s analysis as fact.

Although I don’t claim to have made an exhaustive study of MER expenses elsewhere in the English-speaking world, a survey of information readily available on the internet did produce interesting reading. Although MERs include many of the costs associated with running a mutual fund, the ratios are not all inclusive. Trading charges – the costs of buying and selling securities or bonds – are reported separately in Canada as the Trading Expense Ratio, and are available at In Canada, these TERs are very low. The brief survey that I did showed ratios ranging from 0% on the Mackenzie Sentinel Bond fund, through 0.16% on the Sentinel Strategic Income fund, to 0.36% on the Quadrus Trimark Global Equity fund.

Most interestingly, when I looked outside of Canada, a very different picture emerged. In Britain, for example, The Guardian newspaper reported in November 2011, that trading and soft costs outside of the reported annual management charge significantly raised the cost of investing from a reported 1.5% to an average annual cost of 2.8%. This figure would then be on par or even a little higher than those in Canada.[1]

In Australia prior to 2012, the situation was similar. The listed costs for investing in the Australian Ethical Investment and Superannuation funds, for example, showed administration and investment management fees ranging from 0.9% for Defensive, Conservative and Climate Advocacy, to a high of 1.55% per year for Growth, Smaller Companies and International shares. In addition, there were further indirect costs that ranged from 1.08% for Defensive funds to 0.88% for Growth funds. There were also front-end load costs, withdrawal fees, buy-sell spread charges, performance fees and investment switching fees that were listed and would potentially be applied. Again, taken in total, these costs were certainly comparable with those in Canada during the same period.[2]

The situation in England and Australia from 2012 onwards will be different. Both countries enacted legislation during 2011 restricting the payment of sales and service commissions to financial advisors from mutual fund fees. Instead, both countries have moved to a fee-for-service model, in which fees from financial advisors are billed separately.  While this will certainly make the cost of professional advice more open and transparent, it is still too early to tell what impact these changes will have on the cost of financial advice in these countries.
It may be that the experience of the United States offers a glimpse into the future.

One of the most damning aspects of the 2011 Morningstar report was the apparent gulf between the high level of costs in Canada and what looked to be extremely reasonable average costs in the U.S. The median fixed income expense ratio in the U.S. was 0.75% compared to 1.31% in Canada, while the median equity expense ratio was only 0.94% in the U.S. compared to 2.31% in Canada!

Again, it seems, the devil is in the details. The United States mutual fund market is vastly larger, and more mature than its Canadian counterpart. While the growth of the mutual fund market in Canada is in many ways based on the U.S. model, there are differences. Perhaps the most notable is the manner of advisor compensation.

As already noted, in Canada financial advisors are largely paid through up front sales commissions in combination with ongoing service or trailer commissions paid by the mutual fund company as part of the MER. In Canada, mutual funds are sold on a front-end load, deferred sales charge, or low sales charge basis. In the first instance, investors are charged an up front fee ranging from 5% down to 0%.[3] In the second and third methods, investors pay no fee up front, but would be subject to a withdrawal fee ranging from either 5% or 3% in the first year down to 0% over a period ranging from three to six years should the assets be removed from the investment company. There are generally no charges for transfers between funds. Financial advisors are paid from 50% to 90% of the value of these fees, depending on their brokerage agreement and the size of their investment book.

In addition, advisors in Canada and their brokerages are paid between 0.5% and 1.0% of the MER as a service commission on an annual basis. Again, the advisor would receive from 50% to 90% of this as direct compensation depending on their brokerage agreement.

In the United States, the experience is somewhat different. According to the Bain Report, in those instances where commissions are charged, front-end sales charges are not negotiable[4], and in those cases advisors receive a servicing fee of approximately 0.25% out of what is called a 12b-1 fee, which is listed separately in fund filing documents.[5] Thus, in those cases where advisor commissions are charged in the U.S., there seems to be a higher, immediate up front cost with a lower annual cost included in annual fund fees. This again, however, is not the whole story.

In the United States there is also a very large and comprehensive fee for service system within the mutual fund investment industry. In a fee for service environment, the advisor and mutual fund company do not apply a sales charge, nor does the advisor receive compensation from fund management fees. Instead, the advisor will charge a fee to the client that will vary with the value of assets under administration. According to a survey conducted by FA Insight and reported in the Wall Street Journal, fee for service accounted for 85% of U.S. advisory firm revenue in 2010.[6] Another 2011 study by Dean and Finke surveyed 7.043 Registered Investment Advisors in the U.S., and found that 98.5% charged a percentage of assets under management, and only a small portion received commissions on sales.[7] Interestingly, the Morningstar report downplays the significance of fee for service, noting only: “U.S. expenses are somewhat understated due to the number of investors who pay for investment advice outside of fund related charges”. If the figures from FA Insight are correct, however, the impact of fee for service is considerably greater than ‘somewhat’!

Generally speaking, fees charged vary with the level of invested assets, and range between 0.50% and 2% of assets under management. A client with a portfolio under $500,000, for example, might be charged 1.5% per year, while a client investing between $500,000 and $1,000,000 might only pay 1%. A multi-million dollar portfolio would pay .5% of assets, or even lower. In addition, some firms charge clients a flat fee or hourly rate, either in addition to or in lieu of fees for service, for comprehensive financial planning. In the United States, therefore, the MERs are low because the advisor compensation has been stripped out of the very large number of ‘no-load’ funds. Once the fee for service has been added back into the mix, the total cost to the investor through the advisor channel is quite comparable, and can even be higher in the U.S. for portfolios under $500,000.[8]

Clearly advice costs and, it seems, those costs are roughly similar throughout the English-speaking world.  As of 2012, British, Australian and the American clients generally pay a separate fee directly to the advisor, while in Canada servicing fees generally remain a part of the MER.  Although fee for service is offered in Canada, it still represents a minority of mutual fund transactions.[9]

Based on the admittedly limited research that I have done, it appears that the cost of advice ranges between 0.5% to 2% of the investment amount and more, with Canadian trailer fees roughly in the middle of the pack. Although fee for service regimes have the advantage of being clear and open, rather than hidden, the costs are still real and affect overall rates of return in the same manner as trailer fees.

The Value of Advice

So what does the average client get for their money – either through the fee for service channel or through the payment of trailer fees? There are, after all, no load mutual funds available directly, there are Exchange Traded Funds (EFTs) that offer index linked returns with low MERs, and there are discount stock brokerage accounts available through most banks. What is the ‘value added’ that comes from the advisor?

First and foremost, studies conducted by Ipsos Reid have consistently shown that investors who work with an advisor have more wealth and assets on average than those who do not, and in most cases, those investors started working with an advisor when they had only modest savings. In the U.S., for example, between 2006 and 2010 investors who worked with an advisor averaged returns nearly 3% higher than independent investors even after taking into account the advisor fees.[10]

Secondly, investors who work with an advisor tend to save more regularly, and tend to avoid the more common investment biases common to those who invest on their own.  Simply put, advisors help clients avoid the fear/greed traps that are all too common in times of boom and bust. Advisors act as gatekeepers, helping to avoid panic selling when markets fall, and helping to keep a diversified approach in times of stampedes into investment bubbles.

Thirdly, again based on the Ipsos Reid study, investors who work with an advisor are almost 2 ½ times more likely to hold tax efficient investments such as RRSPs and TFSAs.

Finally, advisors advise! They can be the first line of defense against rash investment moves. They educate their clients over time on a broad array of financial topics. Advised clients are more likely to have disciplined savings programs.  Depending on their qualifications, advisors can and do provide broad direction on tax, estate, and legal questions – usually at no cost.

The advice channel in Canada is certainly not free but, based on the evidence, neither is it overpriced. Costs, all in all, are similar in Canada to comparable countries. The wise consumer should certainly be aware of the cost of their investment program, and the advisor should certainly be transparent in disclosing how they are compensated. In the best of all worlds, after all, clients must receive a benefit for the fees they pay while the advisor deserves to be fairly compensated for their time, effort and expertise.

Brian Ellis, MA. CFP, CLU, ChFC.
July, 2012

[1] Patrick Collinson, “Investment Funds: Hidden fees wipe a third off returns” November 4, 2011
[2]  As of 2012, total fees curiously range from 2.41% on the Balanced Trust to 1.67% for the International Equities Trust, to a very  high 0.99% on their Cash Trust account
[3] According to the 2011 IFIC report “Understanding Management Expense Ratios”, in Canada “Typically, 90% or more of the trades made under this purchase option each year incur no front end commission at all (the commission is waived by the advisor).”
[4] Ibid, pg. 18.
[5] “Canadian Mutual Fund Ownership Costs: Competitive Relative to the U.S. “Mackenzie Financial, September 2010.
[6] Wall Street Journal, December 12, 2011.
[7] Lukas R. Dean & Michael S. Finke, Compensation and Client Wealth Among U.S. Investment Advisors.
[8] According to the Bain report, Over 95% of mutual fund investors in Canada have less than $100,000 on deposit with a given mutual fund manager. If U.S. figures are anywhere near similar, the fee for service charge would then be at the higher end of the scale. With a median equity MER of 0.94% and a fee for service of 1.5%, the overall cost would therefore be 2.44%
[9] Interestingly, according to data from PriceMetrix Inc. and cited by Rob Carrick in the Globe and Mail the average trailer fee paid to advisors in Canada is 0.9%, while the average charge in Canada for fee-based accounts is 1.61%.

[10] The Value of Advice:Report. IFIC, November 2011.

Wednesday, 7 March 2012

January is behind us, and now that most people have had the opportunity to absorb their investment results from their 2011 statements, this seems like a good time to pause and try and place things into a historical perspective.

Dating back to the tech bubble of 2000 through the credit crisis of 2008, investors have been dealing with a frustrating market environment.  In the U.S., for example, the S&P Index has only just returned within the last week to its previous high, set in early 2000, while the MSCI World Stock index is still well down over the past decade. While the Canadian TSX 10 year index has certainly fared better, at a compounded rate of under 7%, it still lags historical averages.

2011 offered little relief from long-term stress. In fact, for a good part of the year if you believed the media, 2011 resembled 2008 with the world teetering on the edge of another credit abyss. In 2011 worry over potential problems became more important than economic reality.  Strong corporate earnings, increasing employment numbers in North America, and continued economic recovery throughout most of the world could not overcome a lack of faith in politicians and governments and the fear of nations defaulting on their debt. 

Throughout the second half of 2011 the debate over U.S. debt levels and the European debt crisis resulted in stock market volatility that was significant, frequent, and affected all markets as investors moved to the dubious safety of bonds despite credit downgrades and the threat of default. All world equity markets had negative returns for the year. Canada was down 11.1%, the MSCI Europe, Asia and Far East index was down 14.8%, and emerging markets dropped 14.8%. The U.S. S&P Index led all G7 nations, with a non return of 0%.

What made the situation even worse were the severe and comprehensive swings in the market. Historically, for example, the S&P 500 index sees a 2% change in daily values once a quarter. In the summer of 2011 such a swing happened, on average, twice a week.

Even worse, instead of stock markets being a mechanism for separating good stocks from bad, everything moved in lock-step in 2011, with no place to hide. Again, in the history of the S&P 500 there have only been 11 days when more than 98% of the stocks that make up the index all moved in the same direction, and 6 of those days occurred in 2011. 

With long-term investment results being moderate at best, and with recent investment results being negative, people are naturally expressing concern. Some are fleeing investment markets for the perceived safety of cash, interest bearing investments, government bonds or real estate. Unfortunately, there is risk associated with every type of investment. At current 1-year GIC rates of 2.5%, for example, it would take almost 29 years for money to double. In fact, with the current rate of inflation running at approximately 3%, the purchasing power of a GIC investment will actually decline significantly over time. For its part, real estate can offer long-term growth, but as U.S. residents have discovered to their cost, housing prices can fall significantly. Although Canada has not, yet, had a significant pull back in real estate prices, it did happen in the early 1980’s and 1990’s, and recent headlines have warned of potential headwinds for the Canadian residential real estate market, with prices currently at all time highs.

Equity investments have historically offered those who have stayed consistently invested higher long-term returns, with the price for those returns being shorter-term volatility.  The emphasis, however, should be on the words “consistently” and “long-term”.  There have been extended periods where stocks have traded within a range for an extended period.  Although these ‘sideways’ markets have lasted, on average, 13 years, the good news is that we are currently in the 12th year of this current cycle. At some point, values will move forward to new highs.

One of the reasons that people tend to fear market volatility, I believe, is that they tend to have a limited sense of their own long-term investment horizon. A 50-year-old couple, for example, will tend to say “ We want to retire at 62, so we only have a 12 year investment period. We can’t afford to wait out this period of volatility.” Their need for investment returns does not, however, stop at retirement. Indeed, statistically speaking, there is currently a better than 50% chance that one of this couple will be alive and needing an income, at age 90. This means that this couple still have a 40-year investment horizon. Yes, there will be a need to provide an income at age 62. However, if their funds are to last a lifetime, they still need to generate the kind of returns that only long-term equity investments have historically provided. They therefore need to maintain a disciplined, diversified portfolio of investments and not be swayed by emotion when the periodic storms of despair sweep the investment landscape. 

As Kim Shannon with Sionna Investments notes: “Long term equity market returns apply only if a portfolio remains invested throughout the volatility.” As the following chart indicates, individual investors have historically had the unfortunate tendency to pull out of a market at the low point, only to get back in at the high point, once ‘greed overcomes fear’. The result is below average returns, constant dissatisfaction, and a failure to reach even market average returns over time.

(The line graph shows the value of the S&P 500 index, and the bar graph shows the flow in and out of U.S. equities. Clearly, investors were selling just at the time they should have been buying)

So where does that leave us going forward into 2012? Having taken part in over a dozen meetings with bank economists and investment fund managers and Chief Investment Officers over the past month, I have noticed a remarkably positive attitude emerging – even among those who have been on the more negative side over the past couple of years. Eric Bushell (C.I. Investments), for example, feels that the announcement by the European Central Bank in November 2011 that it would provide 700 billion Euros in unlimited bank financing, with further lending to come by the end of February 2012 has gone a long way towards resolving the credit situation in Europe. Martin Hubbes (CEO, AGF Financial) agrees. He feels that European leaders are taking the right steps, and that the world is closer to global economic health than it was a year ago.. Both Hubbes and Fred Sturm (MacKenzie Financial) point to encouraging signs that the U.S. economy is getting stronger. Corporate profits are high, employment numbers are surprisingly robust over the past few months, and there are clear indications over the past 4 months that the important U.S. housing market has stabilized, and is even projected to grow (for the first time in 4 years) in 2012.  .
Although there are still global issues to be resolved, Kim Shannon and Gerry Coleman (Harbour Funds) feel that there are several reasons to be optimistic. With markets having already priced in a negative outlook in 2011, equity valuations are now attractively priced.  In some cases, valuations are as low as they were in early 2009. Eric Bushell and many others are particularly positive on U.S. stock valuations. Although the U.S. market has under-performed for over a decade, there seems to be a widespread attitude among fund managers that the stage is set for a comeback in U.S. equities.

There is also a consensus that, with GICs and government bond rates of return at near historic lows, equity dividend yields are appealing. Why invest your money in a GIC with a bank at 1.5%, when that same bank’s stock pays a dividend that approaches 4%? Plus, when the price of that bank’s stock fell (temporarily) as a result of headline news in Europe, the dividend yield on that stock actually rose.  (I,e, an $0.80 distribution on a $20 stock stays the same if that stock price falls to $15. The yield therefore rises from 4% to 5.33%) The holder of that stock is therefore being paid a premium well above interest rates to wait for a market recovery. 

There is no question that there are still global problems that need to be overcome. National debt levels are still too high, and both the U.S. and Europe need to move faster to control their debt issues.  There will continue to be policy mistakes on the global scene, and we have not seen the end of periodic volatility in world markets. Nevertheless, in the words of GLC Asset Management:
Barring a natural disaster, geopolitical crisis or a dramatic 
political misstep, we feel the odds are for a positive surprise,
which  would boost global stock markets should ‘better than 
feared’ news come out of Europe…We are optimistically 
leaning forward on our toes rather than on our heels as far
as our outlook for stock markets in 2012…(and)…we expect
bond markets to lag in 2012.

Over the last few years, since the start of the credit crisis, bonds and bond funds have been the refuge of choice from a world of equity volatility. However with 10 Year Government of Canada matching an all time historical low rate of 1.95% in November, 2011, the days of government bonds as a safe haven may well be numbered.

Since the exceptionally high interest rates of the early 1980’s, when mortgages were renewing at 18% to 20%, there has been a long steady decline in interest rates. That has resulted in a 30-year bull market for bonds and bond funds, since every percentage point decline in rates has resulted in capital appreciation of existing bonds.  Now that a historical low has been reached, we may well be approaching a historical shift in long-term trends. 

Although the U.S. Federal Reserve has indicated that it intends to keep interest rates at current levels through 2014, there is little doubt that eventually interest rates will have to rise. The implications for such a rise are indeed bleak for investors who have become used to steady returns from bond funds. Not only will they be saddled with historic low rates of return on government bonds, but for every 1% rise in future interest rates the capital value of their existing portfolio of bonds will decrease by between 6% and 8%. The prospect for corporate and high yield bonds is not nearly as bleak, given the current significant rate spread between these investments and government bonds, but these options have always had a degree of volatility that the true equity refugee has traditionally been unwilling to tolerate. Gerry Coleman perhaps stated it best. In speaking of those who have relied on bonds and bond funds to provide a reliable rate of return he noted: “Enjoy the party, but dance close to the door.” 

So there we have it. According to those who are paid to know, equities have under-performed over the past decade but offer good value, hope for the future, and should ultimately return to their long term averages. Bonds have been a safe refuge over the past decades but the outlook for bonds in a rising interest rate environment is problematic. The best advice for investors going forward is much the same as it has been in the past. Keep a diversified portfolio that is in keeping with both your risk tolerance and investment horizon. Ignore the short term media storms and blaring headlines, and try as much as possible to keep your emotions in check. Keep in mind that challenges have always created opportunities, and that those who done best over time are those who stayed disciplined.