I was responding to a thread on Red Flag Deals and was astonished to see how many people like a conform to a set of beliefs on Canadian mutual funds. Anyway, I tried to gear them back towards the right direction, but to me, it really doesn’t matter if they understand or not. Both Rockerfeller and Buffett have said: “You can’t beat the herd by following the herd.” The more people who follow the herd, it actually makes things better for me.
Anyway, here were my comments. I hope you will find this informative.
Let me try to shed some light on those of you who are confused about all of this. There are actually two arguments here. First of all, there is the argument that Canadian mutual fund fees are expensive than other countries in the world….and for illustrative purposes, we can look to our neighbors in the south. The second argument is mutual funds vs. ETFs (which most RFDers prefer). Here are my comments:
1.Canadian fund fees vs the US
Over the past few years there have been a lot of negative press regarding Canadian fund fees….courtesy of an academic study done by 3 researchers in the States. They looked at all the fund fees in the world and said Canada is the most expensive. They were academics, so who’s going to question them? Not the press for sure, they’re always looking to capitalize on negativity. (http://randsco.com/_img/blog/0702/fees.pdf)
Recently, Mackenzie tried to make a more accurate representation of Canadian fund fees by asking Bain & Co to look at the differences between the Canadian and US fund industries. Those inherently biased towards mutual funds will for sure scoff at the idea and say “fudge!”. (http://www.mackenziefinancial.com/en…coo_report.pdf)
Now here is the meat of it. I’ve read both studies and here is some interesting information.
For anyone who doesn’t know how fund fees work in Canada, basically there is a management fee, an advisor fee, and operating expenses (and of course taxes). In Canada, the advisor fee is generally 1% annually (for equity funds. Balanced and bond funds generally have lower advisor fees). In the US, they don’t have advisor fees of 1%. they have what are called 12b-1 fees, and they are generally 0.25%. Before you jump the gun and say “A-Ha!”, know this: because 12b-1 fees are so low, advisors in the US are mandated by prospectus to charge a front load fee. This is generally 4-5% of the assets invested upfront. Since the average holding period of a fund in the US is about 4-5 years, that’s the same as charging 1% per year if you amortize it. In Canada, although there are also provisions to charge front load fees, if you’ve ever dealt with an advisor in a large financial institution, you will probably see that they don’t charge this fee 95% of the time (unless you have really few assets with them). Note this: front load fees are not included in expense ratios in the US but advisor fees are in expense ratios in Canada.
Another tidbit: If you don’t think advisors in the US charge front end fees, think again. First of all, they HAVE to charge it…it’s in the prospectus. Secondly, it wouldn’t economically make sense if they didn’t charge it. For an average advisor, in order to make any decent living, you have to get at least $40 million of client money if you charged only 12b-1 fees of 0.25% (0.25% x 40 million x 60/40 or 70/30 split with parent firm = 60-70k income before taxes…probably the same as what engineers make coming straight out of university). Sound right to you? Perspective-wise, 80% of Canadian rookie advisors can’t even get to $20 million in 2 years (and most of these would be let go by their firms). Advisors with $40 million in assets in Canada would be high enough to get an office. That’s how hard it is.
If you think an advisor is gouging you and you don’t think they are worth 1% a year, find one that is. Simple as that.
Secondly, the US fund landscape is totally different than in Canada. Did you know that 401k plans (similar to our RSPs) must hold mutual funds? Employer sponsored 401k plans make up 25% of the US fund industry assets and since there are no advisors there is no advisory fee. Similar employer sponsored Canadian plans only account for 3% of Canada’s assets. Did you know that the academic study took all those 25% and used them in their average? Similarly, the direct/discount channel in the US is 30%. In Canada, it’s only 8%, so practically no advisor fees there either. We may look like Americans, but we sure don’t act like them.
So when you compare fund fees between the two countries, you have to look past the “average”. Even middle school taught you that averages can be exceptionally skewed.
So to recap, let’s do an example. Pretend that gas costs the same or similar in Canada vs the US and that 80% of Canadians use full service, whereas 20% of Americans use full service. You can’t come out and say Canadians are being gouged for gas coz you lump self service charges with full service charges to come up with an average. (maybe it’s a bad example, but it puts the point across)
I do think that the Mackenzie study tries to segment the pure Commission-based advisor in Canada vs the US and compares them apples to apples. They take out the 401k plans, take out the direct to client accounts, and take out the bank channel sales (in Canada). I’m not saying the academic study was bad. If any of you have done any meaning statistical analysis of different countries will know countries are not the same. Look at the differences of just two countries US and Canada! Now try to extrapolate for all these factors for all other countries combined. You’re definitely going to have to keep more than a few variables constant!
2. Mutual funds vs. ETFs
First of all, I’d like to say this: ETFs are good, if they are part of your core portfolio. When you start dabbling in the fringier stuff is when you may get into problems (more on that below).
For those of you who say on “average” (there’s that word again) mutual funds don’t outperform the index after fees, you’re damn right they don’t! But here’s something to ponder about: what are mutual funds “on average”? They are a collection of different portfolio managers running different funds using different methods and styles holding different stocks. Any person with a financial background can tell you that if you lump all those styles and holdings together, you will get something that looks like the index…the more holdings an aggregate set of stocks have, the more it looks like the index as it’s overdiversified.
Fund companies need to make money too. They’re not going to keep a manager that keeps underperforming the market for a long period of time. Shouldn’t you think that this is the basics of running any business? Unfortunately, managers leave or retire, and every year there is a new pool of new managers, some end up doing well, others won’t. I really don’t think lumping these new managers with tenured ones to come up with an average is fair.
ETFs are also passive. It’s not hard to do/replicate. They can hire a person straight out of university to do it. That’s why it doesn’t cost a lot. Active funds require a lot of research, so there is no way active funds’ costs will fall to ETF levels, so stop lobbying for it.
I really think the general public like to trash funds and hail ETFs because it’s easy. If you invest in ETFs, you’re not going to blame yourself if it does bad, nor are you going to blame the market. It’s the market, after all. If you have a chance to point a finger at someone, it’s a lot easier to say the advisor made me buy it, or the portfolio manager dropped the ball. But know this: there are lots of reports online which point to the fact that the average investor makes a lot less money than what an underlying investment made. For example, a mutual fund could have made 18% a year, but the average investor lost 11%! This has very much to do with investor behaviour (which is a whole complete other topic). If you think investors act rationally, you’re in for a treat. They buy and sell at the wrong times. That’s also another use for a good advisor. They give another layer of reassurance and objectivity to ride out bad times. How many times have you been in front of your own discount brokerage account with your itching-trigger finger ready to jump ship? I used to work in a discount brokerage, and I’ve seen that all the time. Every client crushed their account to the ground in 2000. Sure, an advisor can’t make you money every single year, but that’s a function of how investments work, not how an advisor works. The best money managers only outperform the market 60% of the time (you can also read studies to show this all over the net). That’s only 6 out of 10 years. Not everyone can stomach that.
Finally, I’d also like to leave you with some tidbits. ETFs are good for core indices that are efficient and have good liquidity (and also not as volatile). This is because ETFs don’t rebalance their holdings daily. From what I recall, a lot of them rebalance quarterly (someone can correct me here if I’m wrong). For the very volatile indices, it’s hard to match index performance.
Did you know:
From Jan 1, 2007 to Dec 31, 2009: spot oil gained 36%? If you wanted to play that and buy the ETF, the US Oil Fund (USO) lost 26% over the same period! That’s a 60% difference!
Not a good example? Here is one that’s more familiar to you: iShares MSCI Emerging Markets Index Fund (EEM) ETF underperformed its benchmark by 6.7% in 2009. Does that sound like tracking the index to you?
I hope this clarifies some stuff. I am not pro-either. In a perfect portfolio, I would want to hold a core TSX ETF and a core S&P500 ETF and buy actively managed (non-index hugging) mutual funds to complement them. I just don’t like people bashing one thing and embracing another without all the facts.
Share on Facebook
by ProjectMoonlightCafe
no comments