© Copyright 1998
The Globe and Mail
Reprinted without permission
BY ANDREW BELL
MEET Norman Rothery - a quiet and polite voice of dissent amid the current roar of advertising for registered retirement savings plans.
The graduate student of physics at Toronto's York University spends his days making fantastically accurate measurements of the light emitted by hydrogen.
But in his spare time, he's been doing another sort of measuring: Checking the damage that fees - particularly mutual fund expenses - inflict on the value of investors' retirement savings.
"It's really shocking," the 28-year-old says. "For the people who have some understanding of what's going on, mutual funds become at best a short-term trading vehicle. You wouldn't want to use them for a longterm investment."
Mr. Rothery is one of a growing band of cost-paring investors who are realizing what has long been everyday knowledge for investment professionals: Costs and expenses can be the most important determinant of investment returns.
The experts, include William Sharpe, who won the 1990 Nobel Prize for economic science for his investment theories, particularly the link between risk and return.
"The first thing to look at is the expense ratio. . . . If you had to look at one thing only, I'd pick expense ratio," he told a newsletter run by low-cost U.S. mutual fund seller Vanguard Group last year. "On average, every dollar spent is a dollar less for the shareholders."
The impact of costs can be horrendous, warns pension expert Malcolm Hamilton of William M. Mercer Ltd. in Toronto.
In a presentation late last year, he warned that over 25 years, a tax-sheltered mutual fund with an annual expense ratio of 2.1 per cent and an annual return of 7 per cent will leave only 61 per cent of the accumulated capital in the investor's pocket. The remaining 39 per cent will end up in the hands of the fund company.
But how does that innocent-looking 2.1 per cent balloon to 39 per cent? Simply because one-fiftieth of the investor's capital is being sliced away each year. In other words, if the mutual fund achieved no growth at all over the 25 years, Mr. Hamilton says, "it'd be 50 per cent" in the hands of the fund company.
Things are worse if the money is taxable at 50 per cent, he said. In that case, the government gets 24 per cent, the saver 40 per cent and the fund company 36 per cent.
Canadian equity mutual funds have a median expense ratio of 2.33 per cent or more.
Mr. Rothery, the physicist, runs an Internet web site called Directions that offers an Aladdin's cave for a tight-fisted investor who wants to save money.
It includes a catalogue of discount brokers and a calculator that lets you compare their rates, a list of mutual fund dealers across the country that will sell you just about every mutual fund with no commissions, and a detailed breakdown of Canadian dividend reinvestment plans (DRIPs) and stock purchase plans (SPPs) that let you buy shares directly from companies with no brokerage commissions.
DRIPs, which let investors build compound growth by taking their dividends in more stock, and SPPs, which let them buy more stock commission free, have for decades been the cheapest way to buy shares. Companies like them because they build a loyal shareholder base that can be less prone to panic than institutional market players.
"It's really a way of getting people to hold Suncor for the long term," says Ron Shewchuk, spokesman for Calgary-based gasoline giant Suncor Energy Inc., which introduced a DRIP and SPP last summer. The SPP lets investors top up their holdings by between $100 and $5,000 each quarter.
More than 30 Canadian companies - mostly blue-chip players such as BCE Inc., Bank of Montreal and Northern Telecom Ltd. - offer DRIP plans, as do hundreds of companies in the United States.
But the plans can be cumbersome. For one thing, you may find yourself dealing with a somewhat bureaucratic trustee.
And it's "very difficult to keep it in an RRSP," says Cemil Otar, author of Commission Free Investing: Handbook of Canadian DRIPs and SPPs (Uphill Publishing, $16.95.)
To sign on with a DRIP, you usually need to own at least one share already, and that means using a broker. Play your cards close to your vest when placing the order: "If you go to a broker and you say 'I want to open an account and buy one share and do nothing,' they won't let you open an account," Mr. Otar cautions.
A convenient solution, although one that involves some fees, is to join the Toronto-based Canadian Shareholders Association and sign up for its low-cost investing program.
The program lets you invest commission-free in 40 well-known U.S. and Canadian companies, including Coca-Coca Co., Trimark Financial Corp., McDonald's Corp.and Walt Disney Co. You can reinvest all dividends and even make regular monthly purchases with money from your bank account, two of the wonderful advantages of mutual funds. Investors get an annual T5 statement for tax purposes.
Users must pay the CSA's $76 annual membership fee, which includes a magazine and stock-analysis system, plus a $4 administration charge for each stock purchase. For example, that reduces a $100 monthly investment to $96.
So far, about 2,500 of the CSA's 12,000 members have signed up for the program, said association president John Bart, 54, who retires this year as professor of finance at the University of Windsor. "I think people are unsure of how well off they're going to be as a result of equity mutual funds," he said.
The most popular stocks in the plan are transportation powerhouse Bombardier Inc., diversified health player MDS Inc. and Royal Bank of Canada.
Later this year, the non-profit association plans to introduce a group RRSP that will let members shelter their holdings from tax.
The plan, which will carry an administration cost of about $25, "will be the equivalent of a self-directed RRSP," Mr. Bart said.
The CSA program also lets investors own Toronto 35 index participation units and TSE 100 index participation units, both sponsored by the Toronto Stock Exchange, which are the cheapest way to own the Canadian stock market.
TIPS 35 (formerly called TIPS) represent ownership of the biggest 35 stocks on the exchange while TIPS 100 (formerly called HIPS) each give holders a stake in the TSE's 100 biggest stocks. They trade on the exchange just like regular stocks under the symbols TIP and HIP, respectively.
Simply tracking the stock market may not sound exciting, but. most mutual funds can't match the index. The TSE's 300-share composite index produced an annual compound return of 17.5 per cent in the five years ended Dec. 31 but the average Canadian equity mutual fund returned only 15.1 per cent annually.
"The average guy is going to get the average [fund] manager and get the market minus 2 per cent a year," Mercer's Mr. Hamilton says.
TIPS 35 and TIPS 100 come with a negligible management fee of less than 0.05 per cent annually. That compares with an expense ratio of 2.19 on the average Canadian equity mutual fund.
To top up a holding of TIPS 35 or TIPS 100 units, or to reinvest the distributions they pay, a skinflint investor can open an account at a discount broker where an annual purchase of 100 units can cost as little as $31 in commissions.
You can do the same with Standard & Poor's Depositary Receipts, the U.S. equivalent of TIPS, which are also available through the CSA program.
A half-way house for smaller investors who want to avoid costs are index mutual funds, which aim to track the entire stock or bond market while carrying low expenses.
Canadian Imperial Bank of Commerce has been leading the way with expense reductions, cutting total costs on its index funds to 0.9 per cent.
Index funds are attracting more attention from investors like Ted Chen, a systems engineer at IBM Canada Ltd. in Vancouver, who has moved nearly all of his money into traditional actively managed funds such as Bissett & Associates Investment Management and Scudder Canada Investor Services Ltd. that charge no sales fees and offer low expense ratios (less than 1.5 per cent on Canadian equity funds.)
Mr. Chen switched his account last year to discount trader E Trade Canada, which sells virtually all funds with no commissions, after finding that. his full-service broker didn't recommend any low-expense funds. "Every-one has their own agenda, and I don't think all investors realize that," he said.
He's also considering index funds, but he still thinks CIBC's 0.9 per cent is "too high."
In the United States, Vanguard's $53-billion (U.S.) stock market index fund carries expenses of less than 0.2 per cent, but the company doesn't accept orders from Canadians.
"It's just not something we want to get into" yet, spokesman Brian Mattes said, although he added that Vanguard is keeping an eye on the Canadian market.
Back at the Canadian Shareowners Association, assets in the low-cost program are still a tiny $11-million (Canadian).
That's less than one-thousandth of the $11.4-billion in new money that sloshed into Canadian equity mutual funds last year.
Mr. Bart doesn't expect to become a threat to the powerful fund industry any time soon. "Watch out," he tells his well-heeled rivals. Then he pauses: "Hey, I'm only kidding."
Low expense | High expense | Average 5-year | Average 5-year costs return | costs return Balanced funds 1.11 % 12.8% 2.51% 12.3% Canadian equity funds 1.32 15.7 2.60 14.6 International equity funds 1.53 14.5 2.75 11.3 Low-expense funds are the 25% in each category with the lowest costs while high-expense funds are the 25% with highest costs. Annual compound returns to Dec. 31, 1997
1997 1996 1995 1994 1993 TSE 300 total return +15.0% +28.3% +14.5% -0.2% +32.5% Return from median Canadian equity fund +13.5 +25.2 +12.5 -2.0 +29.0
Discount broker Through By Internet telephone or modem Bank of Montreal InvestorLine, $31.00 $25.00 Bank of Nova Scotia Scotia Discount 31.00 24.80 Canada Trust Market Partner 49.00 41.65 CIBC Investor's Edge 43.00 32.25 E Trade Canada 38.88 38.88 Hongkong Bank Discount Trading 40.00 29.00 National Bank of Canada InvesTel 40.00 28.00 Priority Brokerage 57.75 30.00 Royal Bank Action Direct 41.00 29.00 T-D Bank Green Line Investor Services 43.00 29.00 Source: Globe Information Services and companies