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Fund industry isn't reasonable when it comes to fees

One thing you have to admire about the mutual fund industry is the way it flouts the natural laws of economics and business.

Economies of scale rarely happen in fundland, and premium prices often mean the worst performance. The fund industry also wrote the book on bloated cost structures.

Let me pause this rant for a moment to say I like mutual funds just fine. I own some and think a majority of investors should use them, too.

But after reading a Morningstar Canada study on management fees, I'm disgusted with the fund business -- as disgusted as I ever have been.

The study shows that investors paid more than $10-billion in management expenses in each of the past three years and will pay about that much this year. This isn't the problem -- there's a price to be paid for professional investment management and investors are willing to pay it.

Within reason.

Unfortunately, the fund industry has trouble being reasonable when it comes to fees.

Management fees are expressed as a percentage of a fund's assets to create the management expense ratio, or MER. As a fund gets bigger through investment gains and purchases from investors, you'd expect the MER to fall as economies of scale kick in.

Instead, many fund companies have boosted fees as assets grew.

Mark Warywoda, Morningstar's director of analysis, found that 71 per cent of funds increased their MERs from the end of 1995 through April, 2003.

Worse, he found higher MERs in 70 per cent of the funds that increased their assets. For this to happen, fees would have to rise at a higher rate than assets.

This is news to you, I'm sure.

Other than cars, it's hard to think of a product sold with as much price obfuscation as mutual funds.

Yes, fund companies clearly disclose their MERs and they have plain-language explanations in their prospectuses of what the fees mean and their impact on performance.

Big deal. What's really needed is a detailed breakdown on every mutual fund account statement of how much client returns were reduced by management fees. It would be great to see a detailed accounting of what these management fees cover, but one step at a time.

What are the chances of getting full MER disclosure on account statements?

Nil sounds about right. The ugly reason: In the bear market, many fund companies have been scarfing down a lot more in management fees than they've delivered in returns to unitholders.

The average Canadian, U.S. and global equity funds delivered sizable compound average annual losses over the past three years. Unitholders bled, while fund companies bellied up to the MER buffet every year and ate their fill.

Fund companies have to keep the lights on and the portfolio managers paid, so it's unrealistic to expect a notable drop in management fees during bad times. But to just keep plowing ahead with the same over-inflated cost structure while clients are hurting is obtuse behaviour.

The Morningstar study shows that the number of funds available to Canadian investors has grown to 4,600-plus from about 1,000 in 1995. There's hardly a large-size fund company out there that couldn't benefit from taking a machete the size of a Cadillac to its product lineup.

A recent spate of fund companies buying fund companies has resulted in some product consolidation, but we need more. There's still too much flotsam left over from the go-go fund days of the late 1990s, when a dumb idea presented Monday had a good chance of hitting the market as a new fund on Tuesday.

In defence of the fund industry, it's only doing what its customers allow. Too many investors and financial advisers don't put enough emphasis on picking funds with competitive MERs.

This is shortsighted because MERs are a vitally important factor in finding quality funds.

Morningstar notes a correlation between low MERs and high rankings on its five-star fund-rating system. The average fund in the four- and five-star categories had an MER of 2.3 per cent, while three-star funds had an average 2.5 per cent MER and one- and two-star funds had an average MER of 2.78 per cent.

Morningstar isn't the only one saying management fees matter. Last spring, Boston-based Financial Research Corp. said MERs are one of the most useful indicators available when assessing mutual funds.

Increase your chances of investing well by looking for funds with low MERs (don't forget index funds and exchange-traded funds).

MERs aren't the whole story by any means, but they're too important for people to keep ignoring them.

Where do you find low-MER funds? Morningstar said the companies with the lowest dollar-weighted average MERs include SEI Investments, TD Asset Management, Phillips Hager & North, Perigee Investment Counsel, Beutel Goodman, Leith Wheeler and McLean Budden. Also on the list is Barclays Global Investors, the company behind most of the ETFs listed on the Toronto Stock Exchange.

Low MERs mean a company runs a tight ship and doesn't spend money on things that get in the way of returns for investors. If the rest of the fund industry can get its head out of its asset base, it will adopt this model.

© 2007 The Globe and Mail. All rights reserved.

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