Cheap funds help boost your returns
Loads and fees eat away at your profits.
Over the years, this can make a big
difference to the size of your portfolio.
Saturday, May 8, 1999
Allen Minuskin is a bargain hunter when it comes to buying mutual funds.
He ferrets out funds with no loads (commissions) and low fees because he knows those charges can eat away at total returns or profits -- if there are any.
Mr. Minuskin became concerned about fees after last year's slump in the Canadian market. The Toronto Stock Exchange 300-stock composite index posted a loss of 1.6 per cent last year, while the average Canadian stock fund lost 2.9 per cent.
"I don't want to pay fees on top of losing money," the 28-year-old Toronto lawyer says. "I am really concerned about losing more money by fees charged by the mutual funds."
That's why he chose to invest a total of $6,000 in three funds in the Perigee no-load, low-fee mutual fund family when he started buying funds for his registered retirement savings plan this year.
Mr. Minuskin is one of a new breed of fee-conscious investors who are looking for the best deal in mutual funds. Although fees inevitably take a big bite out of one's profits, industry observers say most investors will remain oblivious to this until there is a bear market.
Investor apathy to fees
Investors may be aware of the commissions charged on the sale or early redemption of mutual funds. But they are often not conscious of the less-publicized annual fees that are charged directly to a mutual fund. These fees are deducted from the fund's assets before investors see the returns on their statements.
One reason for this blissful ignorance is that many Canadian investors have traditionally invested most of their nest eggs in guaranteed investment certificates (GICs) and savings bonds where there are "no overt fees," suggests Dan Richards, president of consulting firm Marketing Solutions.
As well, mutual funds are also marketed on performance -- the numbers that investors usually remember -- and the Canadian market has never had a low-fee champion like U.S. index mutual fund manager Vanguard Group.
In Canada, the fee charged to the fund is called the management expense ratio (MER) -- the total of the annual management and operating expenses expressed as a percentage of assets. MERs can vary widely among funds of the same class.
The management fee includes expenses to run the fund and may include marketing expenses and commissions paid to advisers. Operating expenses include accounting, record-keeping, legal, audit, custodial and regulatory fees.
The net return on a fund is calculated after deducting the MER from the gross return. Say a fund chalked up a gross return of 10 per cent and had an MER of 3 per cent, you would then see a 7-per-cent return.
Long-term impact of fees
Malcolm Hamilton, an actuary with pension consultant William M. Mercer Ltd. in Toronto, says investors should be aware of the long-term impact of fees.
He gives the following example: Assume you invest $1,000 in a fund earning 8 per cent annually over 25 years. Before fees, that amount would grow to $6,850.
If you invest $1,000 in a fund with a low MER of 0.5 per cent, you would end up with $6,100. You lose $750 or 11 per cent of your end capital over 25 years.
If you invest $1,000 in a fund with a MER of 2 per cent, your money only grows to $4,290. You lose $2,560 or 37 per cent of your end capital over 25 years. "So it is worthwhile to try to save a percentage point per annum on an MER," Mr. Hamilton says.
Glorianne Stromberg, author of a recent report on the investment industry, agrees that "costs do matter." But she argues that investors are often ignorant of fees because the industry doesn't do a good enough job of disclosing them.
She says companies will disclose the MER percentage in a fund's prospectus or in its annual reports or financial statements but "you never get the long-term impact on your capital from fees." The MER of a fund should be "unbundled" to disclose each expense in the prospectus and other documents, she advocates.
And companies, she says, should also give investors more detailed and graphic information about the impact of an MER over many years. She is a fan of a Web site that helps investors do so: http://www.smartmoney.com/si/tools/fundfees
For Canadian investors, it might seem frustrating to hear that MERs on funds are higher here than in the United States. Some industry observers attribute this to the differences in the two markets.
They say MERs are higher in Canada because this country has smaller funds so it's difficult to get economies of scale on expenses. It's also more costly to file for regulatory approval on funds here because the industry must get approval from all provinces.
In Canada, most funds are sold through advisers and the MERs of Canadian funds have the imbedded cost of advice or commissions. In the United States, nearly half of U.S. funds are sold direct to consumers with lower MERs.
Canadians who choose to buy front-end load funds from an adviser are in a sense getting a raw deal, some industry watchers argue. They pay the same MER as those who buy a back-end load fund, in most cases in addition to paying an up-front commission to an adviser. With U.S. funds, the MER is typically lower on the front-end load than back-end load funds.
A 1998 study by Boston-based Cerulli Associates Inc. says MERs on stock and bond funds are "significantly higher" in Canada. A comparison of asset-weighted MERs revealed a gap between 2 per cent in Canada and 0.94 per cent in the United State.
But Cerulli consultant Dennis Gallant says the MERs are still higher in Canada than in the United States when making an "apples to apples" comparison of funds with back-end loads in both countries.
The main reason, he contends, is that the U.S. fund market is "more mature" than Canada's and expenses are scrutinized more. "We have a lot of do-it-yourself investors, and there is a lot of media attention with regard to costs. And we have more regulation overlooking costs as well so there is an emphasis to keep costs at a minimum or to reduce costs."
Scrutiny in Canada "will pick up when the bear market does kick in," he warns. "People are not going to pay higher costs for underperformance."
One low-fee alternative is index funds, which are passively managed funds linked to stock or bond indexes. Earl Bederman, president of Toronto-based consulting firm Investors Economics, says the trend to lowering MERs on funds is more evident in this category and has been spurred by competition.
He was referring to the fact that relative latecomers such as Royal Bank of Canada and Altamira Investment Services Inc. last year introduced some index funds with MERs as low as 0.5 per cent.
There are also fund-like products called index participation units, which have even lower MERs than index funds, although there is a commission to buy and sell them, just like stocks. In Canada, there are TIPS 35 and TIPS 100, which mimic the TSE 35 and the TSE 100 indexes, respectively. Both have an MER of about 0.05 per cent.
Among actively managed funds, the low-fee ones are usually sold by pension money managers who also offer products to retail investors.
These companies sell no-load funds directly to investors and through discount brokers and don't usually advertise.
Their funds have low MERs because typically they don't have to pay for the cost of brokerage commissions and marketing. Some of the fund families in this group are Phillips Hager & North, Bissett, Sceptre, Mawer, Saxon, Perigee, McLean Budden, CentrePost, GBC and Leith Wheeler.
The disadvantage of dealing with these players is that they often require higher minimum investments of $5,000 or more. High minimums also keep costs down because it's cheaper to deal with fewer accounts.
Direct fund seller Scudder Canada Investor Services Inc., a unit of New York-based Scudder Kemper Investments Inc., came to Canada three years ago and tried to woo investors with low fees, but the business didn't grow as fast as it had hoped.
It found that many Canadians still preferred to buy funds through advisers. That's why it recently struck a "strategic alliance" with a subsidiary of fund giant Investors Group Inc. to create Scudder Maxxum Funds Co. The new entity will continue to sell no-load Scudder funds directly to the public but also plans to sell Scudder-managed load funds with higher MERs through advisers.
But Marketing Solutions' Mr. Richards says the trend to lower MERs in Canada may come in a different way -- such as through the rebates offered by discount brokers on back-end load funds that began earlier this year.
The rebates -- up to 3 per cent on a fund -- have the effect of lowering the MER on a fund and represent an unbundling of the advice component, he says.
Fund watchers' favourites
The trick in investing in cheap funds is to have your cake and eat it too. In other words, you want funds that can also outperform.
"Just because a fund has a low fee doesn't mean it's a good fund," cautions Gordon Pape, author of mutual-fund guide books.
That's why we asked fund watchers for their favourite picks among actively managed Canadian equity, Canadian balanced and foreign equity funds. (See chart below for more details).
In addition to low-fee, no-load funds, they also chose some load funds with low fees. (You can save on sales charges on front-end load funds by buying them with a zero commission from certain discount brokers like Scotia Discount Brokerage, CT Securities Inc. and E Trade Canada.)
Mr. Pape favours Phillips Hager & North Canadian Equity Plus and Phillips Hager & North Dividend Income among Canadian equity funds. Historically, they have both been strong performers, he said. "Given the lousy state of the Canadian market, they haven't lost as much as the other funds."
Among Canadian balanced funds, he suggests Phillips Hager & North Balanced and Mawer Canadian Balanced Retirement Savings Plan.
Among foreign funds, he likes Scudder Global and CentrePost Foreign Equity. The latter is a very small fund with a heavy U.S. emphasis, he added.
Dan Hallett, an analyst for Toronto-based Fundmonitor.com Corp., favours the McLean Budden Canadian Equity Growth and the Bissett Canadian Equity among Canadian equity funds. They have been fairly consistent performers even though this market has caused trouble for many money managers, he said.
Among Canadian balanced funds, he picks Phillips Hager & North Balanced. He also likes Perigee Diversifund because of its management team's record in running pension money.
Bissett Multinational Growth and Trimark Fund are his picks for foreign funds.
Peter Brewster, editor of the Canadian Mutual Fund Adviser newsletter, likes Scudder Canadian Equity and Bissett Canadian Equity among the Canadian stock funds. They offer above-average returns with low risk, he said.
For Canadian balanced funds, he recommends Bissett Retirement Fund andPhillips Hager & North Balanced Fund.
Among the foreign funds, he likes Scudder Global Fund and Trimark Fund.
Scott Clayton, associate editor of Canadian Wealth Advisor newsletter, likes Scudder Canadian Equity and Bissett Canadian Equity because of their "high-quality stock holdings," conservative approach and diversification.
His newsletter does not recommend Canadian balanced funds. Among foreign funds, he favours Templeton Growth and Trimark Fund.
TOP PICKS AMONG LOW-FEE FUNDS
Year ended March 31
Category MER 1 2 3 5 10
Phillips, Hager & North
Canadian Equity Plus 1.16% -7.8% +8.1%.+11.8%.+11.7%.+10.3%
Phillips, Hager & North
Dividend Income 1.13 -4.7 +21.1 +25.6 +18.7 +14.0
Cdn. Equity Growth 1.75 -11.0 +7.0 +13.9 +11.4 +9.6
Bissett Cdn. Equity 1.18 -13.3 +11.2 +17.1 +14.6 +13.0
Scudder Cdn. Equity 1.25 -11.6 +14.3 +19.5 - -
Phillips, Hager & North
Balanced 0.88% +1.8%.+10.5%.+11.9%.+11.4% -
Mawer Cdn. Balanced RSP 1.00 -1.3 +9.9 +11.6%.+10.7 +10.5
Perigee Diversified 0.95 -4.9 +10.4 - - -
Bissett Retirement 0.23 -2.5 +11.1 +13.7 +12.8 -
Scudder Global 1.75% +9.1%.+17.8%.+16.9% - -
CentrePost Foreign Equity 1.75 +12.7 +23.8 +21.0 +17.0 -
Bissett Multinational Growth.1.34 +4.1 +23.1 +23.6 - -
Trimark Fund* 1.52 +0.3 +10.4 +10.8 +13.1 +14.9%
Templeton Growth* 1.97 -5.3 +8.4 +11.3 +10.7 +13.0
Source: Globe HySales