April 7, 2008

Fund fees revisited
Number twisting continues with fees

It was almost two years ago when a draft research paper - Mutual Fund Fees Around the World - made waves by proclaiming that 'total shareholder costs' for mutual funds sold in Canada were the highest among the 18 developed countries studied. Industry critics and investor advocates ran with the paper's figures, without scrutiny, to pad their case that the fund industry regularly sticks it to investors.

I was taken aback because the initial figures looked dead wrong and the authors themselves labelled their paper as a 'draft' - cautioning readers not to focus on the raw (unadjusted) fee differences between countries. Last May, a revised version - still in draft form - was released to the media and the industry.

Its figures had been tweaked. And while the overall rankings of total shareholder costs no longer showed Canada as the most expensive country, many media pundits and industry commentators continued to perpetuate the myth that Canada is the 'most expensive mutual fund market in the developed world'. To this day, I still see and hear the paper cited as a source to make this claim.

Last July, the authors released a final version which is slated to be published later this year in a journal called the Review of Financial Studies. I thought it would be interesting to take figures from five versions of the paper and illustrate how the fees and rankings for Canada changed over time.

Publishing Date	Total Shareholder Costs* (Canada)	Total Shareholder Costs* (Denmark)	# of countries with TSC of 2% or higher
Nov 2005	4.63% (highest)	2.54% (2nd highest)	15
Feb 2006	4.66% (highest)	2.54% (2nd highest)	16
May 2006	4.66% (highest)	2.54% (2nd highest)	16
May 2007	2.41% (2nd highest)	2.55% (highest)	8
July 2007	2.41% (2nd highest)	2.55% (highest)	8
Source: Mutual Fund Fees Around the World, using data from around the end of 2002. * The authors define 'Total Shareholder Costs' as the published expense ratio, plus an estimate of annualized loads or sales charges assuming a five year holding period.

Bear in mind that most of the issues I identified in my earlier article (linked above) remain. The authors did not attempt to tease out country-specific nuances, such as fund classes used in fee-based accounts that are included in some other countries' average management expense ratio (MER), while they are excluded from Canadian figures. Also, fund-of-fund MERs, which in Canada must include fees of underlying funds, are not calculated similarly across all borders.

While commentators used the higher Total Shareholder Cost figure found in early versions of this paper, current citations now focus on MER. Why? Because on a total shareholder cost basis, Canada is no longer the most expensive country - even when country-specific nuances are excluded which may show Canada more favourably. This has resulted in some cherry-picking of the paper's figures.

Enter the Barclays campaign

Barclays Global Investors Canada recently launched a marketing campaign - called Ask the Right Questions - supposedly aimed at provoking discussion between clients and their financial advisors. The sponsor of low-fee iShares exchange-traded funds (ETFs) poses questions such as these in its campaign:

• Canada has the highest MERs in the developed world. Should your clients care?
• Your clients' funds aren't doing as well as their benchmarks. How concerned are you?

Some investor advocates have praised Barclays for its campaign. Being ever the skeptic, I see all marketing campaigns as self-serving, by definition. I don't know of any for-profit organization that pays for full page ads in national newspapers without expecting a sufficiently high profit in return.

Don't get me wrong; the idea of fostering advisor-client discussion is a worthy endeavour. But the claims they make about fees and mutual fund underperformance are missing key pieces of information.

Barclays sees value in professional advice. It has a whole division that focuses on courting financial advisors and providing them with business building tools (just like most mutual fund companies). So, let's look at their two points, which relate specifically to fees.

Barclays claims that Canada has the highest MERs in the developed world. Interestingly, they make this claim without any reference to the above research paper - as if it were a commonly accepted fact. The question that occurs to me, however, is neither posed nor answered. If we take the average iShares CDN MER and add the typical advisory fee charged by fee-based or fee-only advisor; how would that total cost compare to MERs of other developed countries' funds?

The average iShares CDN MER is 0.43%. Advisory fees start at 1.00% to 1.40% annually based on the fee schedules I've seen. Add GST to the advisory fee and you come up with a total cost (excluding brokerage fees) of between 1.48% and 1.90% per year. The 1.48% figure would rank third among developed country MERs. The 1.90% figure would rank the same as Canada's overall average. But I guess those figures don't make for a convincing marketing campaign for low-fee funds.

The other related claim says, "Your clients' funds aren't doing as well as their benchmarks. How concerned are you?" Again, when you subtract 1.48% to 1.90% from the index returns, how does this claim stand up? Barclays doesn't tell us. And since history shows that a significant amount of broad indices' total returns are made up of reinvested dividends, how do the numbers look when also deducting the brokerage fees and cash slippage resulting from trying to reinvest all of the distributions which are not automatically reinvested?

The point of my challenges are not to beat up on fee-based or fee-only advisors. Indeed, I fully support greater transparency and accountability. But I also support apples-to-apples comparisons. The vast majority of mutual funds include fees for advice. ETFs, including iShares, do not. So, for investors that need or want advice - clearly the target of Barclays' campaign - Barclays' claims are misleading.

A more transparent advisory relationship has many benefits. While fees can be lower in such an arrangement, they are not always lower. Instead, the value of greater transparency and accountability should be promoted over a potentially meaningless fee gap.