In the November 2010 issue of Investment Executive I reviewed a few different academic papers that attempted to answer the question gracing the title of this blog post.  Unfortunately, space constraints precluded me from detailing the titles of the papers and the names of the authors.  So, below I’ve detailed and linked to the three papers referred to in the above IE article – in their order of reference in the article.

In Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry, Daniel Bergstresser, John Chalmers and Peter Tufano found that the performance of U.S. mutual funds bought by do-it-yourself investors outperformed those funds sold by financial advisors.

A 2008 paper by Geoffrey Friesen and Travis Sapp, Mutual Fund Flows and Investor Returns:  An Empirical Examination of Fund Investor Timing Ability, examined the gap between investor return and published returns of U.S. index funds and actively-managed load U.S. stock funds.  They found that index fund investors fared relatively better overall.

Financial Advisors:  A Case of Babysitters?, by Hackenthal, Haliassos and Jappelli, 2010 studied data from a German brokerage firm and found that advised accounts didn’t fare well compared to non-advised accounts.

While one of these studies appears to have missed the mark, the others simply suffer from a limitation that applies to all such studies.  These limitations were nicely summed up in a recent blog post by economist and author Larry MacDonald, which elicited a slew of comments.  The main points:  financial advisors’ value-added is more behavioural than the selection of any product and it extends beyond the investment portfolio.

The recently announced deal reached by Covington Fund II Inc. and all of VenGrowth’s retail labour sponsored investment funds (LSIFs) has sparked a bit of controversy and attracted another party into the mix.  The Covington-VenGrowth deal, announced recently, would see all VenGrowth LSIFs merged into the Covington Fund II Inc.

The controversy

Since VenGrowth Capital Management (VCM) would be terminated as investment managers upon the deal’s closing, VCM would be paid a termination fee (which is part of the investment management and administration agreements between the funds and VCM.  Termination fees would total about $19.8 million (or $22.3M if HST-taxable).  This represents about 5% of the total assets across all five VenGrowth LSIFs.  These fees would be paid by the VenGrowth funds.

In part to ‘sell’ this deal to shareholders, a Covington Q&A document alludes to the potential to lower fees.  In other words, VenGrowth has simply failed to raise new money.  And since many of their funds have frozen redemptions, assets have been shrinking – which in turn has pushed up annual fees and expenses in percentage terms.  This deal is implicitly stating that Covington will be more successful at raising new money.  And merging all of the funds into a single LSIF will help with cost control.  That’s no guarantee of course.

Another item of concern is the financing cost that will be involved in this deal.  A couple of sources peg the cost at between 10% and 15% annually on the borrowed funds.  Money may be borrowed, for instance, to fund the cash needed to pay out redemptions for those who choose one of the redemption options proposed as part of this deal.

Competing offer

While VenGrowth notes that a few bidders were at the table, it sounds like LSIF consolidator GrowthWorks Capital (a unit of publicly traded Matrix Asset Management) was not invited to make an offer.  Indeed, GrowthWorks is gathering its troops to mount a grassroots campaign to buy some time.

It is soliciting NO votes to the proposed Covington purchase of VenGrowth LSIFs.  They stated, in a proxy circular released yesterday, that they can offer a better deal for shareholders.  They want all VenGrowth shareholders to vote down the Covington deal to allow more time for GrowthWorks (or anyone else for that matter) to formalize a competing offer.

Between a rock and a hard place

It is unfortunate that there are not any great options available to frozen LSIF investors.  If no deal is made – a possibility if the Covington deal is rejected – VenGrowth would gladly continue managing the funds (and continue to collect fees).  But assets would likely continue shrinking which would keep pushing up annual fees.  And the spiral of asset shrinkage would accelerate toward an ugly wind-up.

The Covington deal is a better deal than no deal – but it’s too early to know if it’s better or worse than what may materialize from GrowthWorks.  VenGrowth funds’ boards of directors vetted a few offers but it makes sense to put at least two competing offers in front of VenGrowth shareholders to give them a choice.  And if invetors don’t exercise their rights, they could find themselves frustrated later with no recourse.  Just ask VentureLink investors if they wished they’d taken their voting rights more seriously.

In a recent Globe and Mail column, Shirley Won wrote about how investors in VentureLink ‘capital repayment’ labour sponsored investment funds are not getting their capital back.  The article quoted a financial advisor – who bought the funds for himself and his clients – who is upset that VentureLink isn’t holding up its end of the bargain.  One could argue, however, that this is simply a case study in a lack of due diligence.  Page 1 of the November 2002 prospectus for these capital repayment funds lists the investment objectives as:

The investment objectives of the Income Fund are: (i) to generate a superior level of income by making debt and equity investments in a diversified basket of established eligible businesses operating in traditional industries and investing in reserves; and (ii) to preserve and enhance the net asset value of the Income Fund.

But you didn’t have to dig too deeply to find some pretty stern warnings.  In fact, on page three of the prospectus is a big paragraph – all in bold print – that begins with:

The Class A Shares are highly speculative in nature.

But it goes on to say:

An investment in the Class A Shares of the Income Fund is appropriate only for investors who have the capacity to absorb a loss of some or all of their investment. There is no guarantee that an investment in Class A Shares will earn a specified rate of return or any return in the short or long term. There is no assurance that changes will not be introduced to federal or provincial legislation which, if unfavourable, could impair the investment performance of each Fund and the ability of the Income Fund to attract future investment capital.

So, it required reading just the first three pages of the prospectus to at least trigger some questions around the capital repayment feature.  These are admittedly easy observations to make in hindsight.  But in a February 2004 article titled Take a pass on capital repayment LSIFs, I didn’t dance around my advice to steer clear of these gimmicky funds.  I didn’t get far enough to even read the prospectus.  When I realized that the capital repayment feature was dictating what kind of investments the fund could buy, it was clear to me that this was not an investment-driven product but rather a marketer’s dream.

While the Globe article touches on the subject, I would guess that investors will be unable to compel VentureLink to fulfill the capital repayment part of the objective.  Searching on www.sedar.com for documents on these funds, I found an October 2010 filing of the voting results of these funds.  Most of the wording is very standard but one part jumped out at me.  The vote on the special resolution of, “…the adoption of the investment objective of the amalgamated fund as more particularly described in the accompanying Circular“.  This sent me in search of the objective of the amalgamated fund.

This lead me to a 114-page Circular containing details of the special meeting and resolutions.  Among the resolutions was a proposed change of investment objective (on page 15) from the original one (i.e. generating income, preserve capital) to:

The fund’s objective will be to realize long-term capital appreciation by making debt and equity investments in a diversified portfolio of securities in eligible Canadian businesses and by investing in reserves, including debt instruments whose returns are linked to the performance of the TSX and the financial services sub-index of the TSX.

A sufficient number shareholders seemingly voted in approval of this and many other changes.  It’s likely that investors (and the advisor in the article) did not read the beefy circular and, as a result, were unaware of the change in objectives.  Perhaps people will feel better trying to fight the firm on this point given that marketing material was somewhat inconsistent with the prospectus.  If unsuccessful, however, this may be another in a long list of examples – such as Portus – of how important it is to read offering documents and pay close attention to risk factors that are highlighted for you.

The Globe & Mail recently reported that indexing giant Vanguard has surpassed Fidelity as the world’s largest mutual fund company.  The article poses the question of whether this event indicates a growing interest in index-investing.  I think it is but not for the reason that may be apparent.

Touched on in that piece is that long-established index mutual funds – most of which are offered by banks – haven’t seen much growth in assets over the past few years.  The growing interest in index-investing is most obvious in Canada’s growing exchange-traded fund (ETF) market. I was quoted as saying the following on this trend:

With more choice from ETFs, there is going to be some money that migrates there,” Mr. Hallett said. “And some of the bank index funds are awfully expensive. … I would say the average cost difference between an equity index mutual fund and ETF would be about 30 basis points.”

Some clarification is worthy.  First, my index fund vs ETF cost difference was an estimate – not the result of any recent calculation.  Second, the above quote doesn’t fully capture my view on this.

The ETF industry has adopted too many of the mutual fund industry’s bad habits – i.e. proliferation of  narrow-focus and specialty products.  The ETF industry has grown more than the index mutual fund market in Canada because ETF sponsors continue to pump out product.  If the fund industry taught ETF sponsors anything, it’s that cranking out new products is the key to attracting more money from investors.

Morningstar’s database lists 176 ETFs that trade on the TSX.  But less than 10% of those have existed for five years.  Fully 144 TSX-traded ETFs were born since 2007 – 45 so far this year; 37 in 2009; 35 in 2008 and 27 in 2007.  At least seven Canadian ETFs have folded (i.e. four from TD Asset Management, the original TIPS 35 & HIPS 100 which merged into XIU in 2000, and the SSgA Dow Jones Canada 40).  This growth dwarfs the few launches of quasi-index funds from the likes of Invesco PowerShares, DFA and Pro-Financial.

From a business perspective, the fact that banks have launched very few index mutual funds can be viewed as a negative.  But from the viewpoint of investors, it’s a good thing.  As author Barry Schwartz thoughtfully detailed in The Paradox of Choice, increased choice quickly crosses a point beyond which people are worse off.  I’ve seen the same phenomenon at work for years in the investment industry.

ETFs are elegant vehicles that hold great potential.  But product proliferation combined with ease of trading spell decreased investor returns.  What a bitter irony.

See also ETF Rule:  Keep it simple

I recently challenged gold bulls to ask themselves tough questions before devoting significant dollars to the yellow metal.  A related topic – the investment merit of gold – was the topic of discussion on our panel on The Early Shift this morning on CBC Radio One (Windsor).

During the discussion I repeated Warren Buffett’s great quote on gold.  I knew that I couldn’t remember it verbatim so the actual quote, from a 1998 talk at Harvard University, is below:

It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.

In the interest of fairness and disclosure, I authored a detailed quantitative report on gold on March 24, 2009 in which I warned that gold’s very volatile price often leads to disappointment (particularly when purchased after a strong rise).  Since that time, the closing price of SPDR Gold Shares has risen 17% in Canadian dollars (or 39% in U.S. dollars).  I also note that a global unhedged diversified stock portfolio (i.e. 34% in Canadian stocks, 33% in U.S. stocks and 33% in overseas developed stocks) more than doubled gold’s performance over the same period.

Only time will tell if my cynicism about gold is right or not.  However, our March 24, 2009 bulletin did conclude that investing in gold as a portfolio diversifier has been very effective – a role that I continue to believe is valid.  My concern is more focused on how carried away investors can get with gold in terms of unusually high allocations and expectations for this often-debated commodity.

My article in this morning’s Globe & Mail offers tips to help investors retain more of the performance available to them.  As I jotted down the first tip – write down your investment goals – I found myself writing down something to the effect of, “…many academic studies confirm the benefits of writing down your goals“.

Then it occurred to me that while I believed this to be true, I couldn’t think of a single study that actually confirmed this belief.  As I searched the Internet for a reputable reference, I quickly found that no big study exists.  A 1996 article in Fast Company magazine offers the best account of trying to track down the often-cited 1953 Yale study – concluding that it’s an urban myth.  But I did find one study.

It didn’t take my long to find a few references to Dr. Gail Matthews, a professor of psychology at Dominican University of California.  Dr. Matthews conducted a small, short-term study which supports the practice of documenting goals.  But a periodic review of goals and inserting some accountability (i.e. involving another person to hold you accountable) are important steps.  And it’s why working with a financial advisor can really help people and why so few do-it-yourselfers lack the discipline to invest successfully.

Most financial journalists in Canada charge that the Canadian investment fund industry lacks the kind of price competition we often see in the U.S. industry.  This is true.  But like the people, Canadian investment fund price wars exist though they’re a little tamer.  Interestingly, the latest launch by Horizons BetaPro raises other questions.

The print and online media quickly picked up on the launch of Horizons BetaPro S&P/TSX 60^TM Index ETF (HXT/TSX) since the new ETF, which sports annual fees of 0.08%, was billed as Canada’s cheapest ETF.  And in BetaPro’s ad campaign for the new product, HXT was held out as the first example of true direct price competition among Canadian ETFs because it’s the first incidence of two competing ETFs tracking the identical index.  While it’s been more than a decade, we have seen this kind of price competition before.

Past price competition

In the late 1990s, mutual fund companies began launching index funds.  TD Asset Management was the leader in Canada, having launched its index funds in 1985.  But in October 1998, Altamira launched its family of index funds, which sported MERs of 0.53% annually.  A year later, RBC Asset Management launched its family of index funds with fees matching those of Altamira.  By late 1999, TD launched the series-e units of its index funds, with MERs of 0.3% to 0.5%, thereby under-cutting all other index mutual funds.

The launch of BMO index ETFs marked the first real level of price competition among TSX-traded ETFs.  HXT’s introduction simply raises the game but its synthetic structure may attach strings to its lower fees.

Credit risk

HXT does not invest in stocks directly to track the S&P/TSX 60 Total Return Index, choosing instead to track the index via a total return swap with National Bank.   (Note that National Bank owns a stake in its affiliate, AlphaPro, and is the counterparty to BetaPro’s leveraged and inverse ETFs.)

HXT will hold money market instruments while National Bank will hold the basket of stocks making up the S&P/TSX 60 Index.  The swap is basically a legal contract requiring HXT to pay National Bank the return on its money market instruments; and requiring National Bank to pay to HXT the total return on its stocks.

In the case of National Bank’s failure, HXT’s assets would be safe but the return on those assets – i.e. the index total return – would be at risk of not being paid to the fund.  In that kind of scenario there could be other negative implications but as far as the swap is concerned, only the ‘returns’ are swapped not the notional value.

Horizons BetaPro has played down a scenario including National Bank’s failure.  To be fair, this is a very small probability event in my view.  But it’s one of those scenarios that has a small probability but a potentially significant cost if it ever happened.  HXT’s investors are being compensated for this small risk exposure in two ways.

First, despite comments by at least one competitor to the contrary (see Jon Chevreau’s blog), the use of swaps or forwards is generally accepted as being able to legally ‘convert’ all forms of income to capital gains.  Given that large cap ETFs are generally pretty efficient, the size of this benefit is questionable.

Second, HXT’s expected 0.08% MER is about half of the cost of its nearest competitor (or 10 basis points cheaper than XIU).  This price difference is effectively what HXT investors are being compensated to take on this credit risk.

As I reviewed HXT’s prospectus, I wondered if investors would accept the complexity and small credit risk that comes with HXT in exchange for 8 to 10 basis points of fee savings.  Personally, I would probably prefer the plain vanilla version for such a small fee difference.  But it will be worth getting greater clarity on whether HXT and its investors are fairly compensated for credit risk exposure – an issue I will address in a future post.

In this weekend’s Report on Business, Rob Carrick nicely captured my mixed feelings about balanced funds.  As I noted in a recent Wealth Steward post, it’s critical to keep an eye on fees when choosing your bond exposure.  Yet, the vast majority of balanced funds – which hold significant stakes in bonds – sport management expense ratios that are on par with stock funds.  The reasoning goes something like this:  the firm charges a management fee that blends its fees for stock and bond management, plus something extra to manage the asset mix.

As a result, fees average about 2% for all balanced funds.  The table below, however, shows balanced fund average MERs (asset-weighted) broken out by type of balanced fund, calculated in late 2009 using data from Morningstar Canada.

With Canadian bond yields hovering around 2.8%, the challenge becomes painfully obvious for balanced funds.  Accordingly, the larger the bond component, the less the potential to add value and the more important the MER should be in the selection process.  In Rob Carrick’s article I provided three balanced fund suggestions for investors dealing with an advisor and a few others for do-it-yourself investors.

Early in my career, I didn’t recommend balanced funds because of the fees.  But when I became aware of the investor behavioural benefits, I started recommending balanced funds.  Since investors only see the smoothed return path of the ‘balanced bundle’, investors are less prone to panic and greed – leading to longer holding periods which, in turn, leads to higher investor returns.

In other words, investors actually realize higher returns in balanced funds compared to what they earn investing in individual stock and bond funds.  To clarify, it’s important to distinguish between performance published by mutual funds and the returns that investors actually realize over time.

See the chart below which I prepared for a conference presentation two years ago.

The chart shows that investors in IFIC-reporting mutual funds from December 31, 1993 through July 31, 2008 experienced lower returns in stock funds compared to their returns in other long-term (i.e. non-money-market) funds.  There are many reasons for these disappointing results, which I’ll explore in an upcoming article.

See also:  Volatility measures behavioural risk

A few years ago, a research paper by three academics claimed that Canadian mutual funds levied higher average fees than funds in seventeen other countries.  Since average Canadian fund fees are high, the media jumped all over this research – despite being incomplete.  Reading through many versions of the paper, it became clear that the core data and underlying assumptions were questionable.

Given that inaccurate figures from the paper were being quoted in otherwise reputable publications, I wrote detailed critiques on this paper in this 2006 article and in this piece from 2008.  I felt like the lone public voice warning against quoting research on global fee comparisons that hadn’t attempted to tease out regional differences in disclosure and advisory fee structures.  So, I was pleased to see a recent article in The Telegraph slamming the British fund industry for hidden charges that can double or triple published expense ratios.

The article appears to validate one of my concerns with the earlier academic research article.  In particular, the Telegraph article states:

When a saver invests in an ISA, unit trust or other fund, they are informed that they will pay an “annual charge” – typically 1.2 per cent of the value of their savings. The majority of funds levy exactly the same charge.

But the firm also deducts a range of other vaguely defined fees – covering everything from research to office costs from the savers’ money [similar to Canadian operating expenses].

In particular, funds charge savers fees and commission every time they buy or sell shares. In some funds, hidden fees can be more than three times higher than the publicly-released annual fees.

These fees are nothing new to Canadians; they are operating expenses and costs incurred by funds when trading stocks.  But a more complete total cost calculation offers interesting insight.

The Telegraph article uses Morningstar data in citing a typical expense ratio of 1.7% for U.K. funds.  The article further pegs typical trading commissions at another 1.35% per year.  By comparison, Canadian expense ratios are higher – I calculated 1.9% for all funds or about 2% excluding money market funds – but trading commissions are seemingly half of the U.K. figure found in the Telegraph article.

I haven’t done a study of U.K. fund fees but on the surface, this Telegraph article simply confirms my central critique of the academic paper – i.e. total shareholder costs weren’t equitably counted across all countries studied.

The academic paper, which used 2002 fee data, shows U.K. expense ratios at 1.3% vs. 2.2% in Canada.  If we add the above trading commission estimates we get total fund costs of 2.6% in the U.K. compared to 2.8% in Canada.  Only looking at expense ratios, Canada appears to be almost twice as expensive as the U.K.  A more complete fee picture, however, makes them almost identical.  Canadian fees may even be more competitive using more current data.

Then there is the issue of advisory fees, which are mostly embedded in Canadian fund fees so they’re counted more than in fund markets like the U.S. or the U.K.  But the academic study did not attempt to count advisory fees that investors pay separately on lower-fee funds.  I have no doubt that U.S. funds are hands-down the world’s cheapest.  While Canadian fund fees are higher than I’d like, on average, I can’t help but speculate that Canadian funds are more competitive than we realize when all costs are counted.

My aim isn’t to defend the fund industry.  I simply maintain that no study is sufficiently complete to make meaningful global comparisons of the total costs that investors bear to invest in and hold mutual funds.  Until that happens, any statement regarding where Canadian fund fees rank among its global peers is simply speculation.

More importantly, I’ve argued that the debate over average fees is simply academic.  In the April 2008 issue of Investment Executive I reason that average fees don’t matter if we have enough breadth of choice to satisfy do-it-yourself investors and advice-seeking investors (whether their advisors are paid by commissions or separately-billed fees).  In other words, averages are meaningless if everyone has what they need.

(Post Script:  For a related story, see Canadian Fund Fees Revisited which was published shortly after this post.)

In this morning’s Globe & Mail, I gave an overview of investors’ three main options for bond (or bond-like) exposure in taxable accounts.  It seems at least two preferred share funds escaped my radar.  I’d also like to touch on some other products – some mentioned in the article and some not.

First, the mea culpa.  There aren’t many preferred share funds around.  In fact, I thought I listed all of the open-ended preferred share funds but neglected to mention the Invesco PowerShares Canadian Preferred Share Index Class and the JOV Leon Frazer Preferred Equity Fund.  Both funds should sport management expense ratios in the 1.8% to 1.9% range, including HST.  This is competitive with other preferred share funds mentioned in the article.

Hymas Investment Management‘s Malachite Aggressive Preferred fund, however, deserves a special mention.  While it is only available to accredited investors – i.e. it is sold by Declaration of Trust, not by Prospectus – the fund offers more transparency than any prospectus-sold mutual fund.  For example, while mutual funds now refuse to show trading summaries (because they don’t have to), Hymas freely posts statements of portfolio transactions on his website.

Hymas, who previously ran the GBC Bond Fund, also boasts a track record that is nothing short of superb.  With large investors having exited the preferred share market over the past 15 years, the opportunity grew for astute investors like Hymas to capitalize on this inefficient market.  While we have yet to complete our formal work on Hymas and his fund, there is a lot to like.  You can also peek into Hymas’ brain by checking out his blog – PrefBlog.

Finally, I deliberately omitted the ecclectic mix of closed-end preferred share funds, like those offered by Sentry and RBC.  At one time, more of these funds existed.  But I left them out of today’s article because they can involve additional liquidity risk and can sometimes use leverage.  Those are additional risks that otherwise conservative bond investors probably don’t want or need.