Memo to: Ontario Securities Commission
From: Mutual fund investors
Subject: A small but significant gap in the information about fees and expenses that fund companies provide their unitholders.
As you're aware, you people at the OSC are accepting comments until July 27 on a set of rules covering investment fund disclosure of financial information. What's missing is a requirement that fund companies clearly show how returns are affected by the brokerage commissions their funds pay.
Almost every other expense incurred in the running of a mutual fund is included in its management expense ratio. The MER combines things like manager salaries, research costs, office expenses and regulatory fees, then expresses the overall cost as a percentage of the fund's assets.
MERs are a great indicator of fund costs, except for one problem. They don't include the commissions the fund pays every time its manager decides to buy or sell some shares.
Brokerage costs may be negligible enough to reduce fund returns by only a few hundredths of a percentage point, but in heavy-trading funds they could conceivably chop something like 1.5 of a point off what we investors receive.
The average Canadian equity fund has an MER of about 2.8 per cent. Add another percentage point onto that and you're looking at a fund that has to jump a 3.8-per-cent hurdle every year before it makes even a cent for investors.
Fund companies don't hide the brokerage fees they pay, but they could certainly make it easier for investors to get this information and put it in useful perspective.
You can find out the total brokerage commissions paid by a fund in its family's annual or semi-annual report. Just flip to the back of the book to the section called Notes to Financial Statements and you'll find a dollar amount.
That's next to useless for us investors. It would be much better to have brokerage expenses calculated as a percentage of fund assets, in just the same way as almost all other fund expenses are expressed in the MER. This handy number -- let's call it the trading expense ratio for now -- would show investors clearly how much a fund's trading costs reduced its returns.
The sensible approach would be to fold brokerage commissions in with other fund expenses so they're reflected in the MER. But that's not going to happen under Canadian accounting rules.
Most investors would intuitively include brokerage commissions in the fees, charges and expenses that must be included in the MER calculation. But accounting guidelines call for these commissions to be factored into the realized gain and loss in the trading of securities, and not added to expenses.
Disclosing the impact of brokerage fees on returns would give investors a better picture of how efficiently a fund is run. Despite what some people in the fund industry will tell you, low fees are a key determinant of fund performance.
Another benefit to this added level of disclosure is that it would help investors and investment advisers better understand how particular fund managers operate. Low brokerage commissions would indicate a more conservative, buy-and-hold manager who seeks out quality stocks, while high commissions suggest a hard-trading market timer whose fund would be volatile and thus suitable for more aggressive types.
While investors wait for the OSC to release its fund disclosure rules in their final form, the best source of information on how actively a fund is traded is an indirect one.
In every fund company simplified prospectus, there's a section for each individual fund called Ratios and Supplemental Data. Look for the data on portfolio turnover, which tells you how much of the fund's portfolio has been sold and replaced in a year.
Portfolio turnover of 100 per cent indicates enough trading to theoretically replace every single stock in the portfolio once over a year. In reality, some stocks may have been sold several times while others were never sold.
Dan Hallett, president of Dan Hallett & Associates Inc. in Windsor, Ont., offers a simple calculation that roughly approximates the same trading expense ratio that you OSC folks should require fund companies to adopt. Just take the portfolio turnover number and multiply by 0.4. Thus a fund with 150-per-cent portfolio turnover would be giving up something like 0.6 per cent of its returns to brokerage commissions.
The fund industry already does a pretty good job of disclosing costs through MERs, so it's not a stretch for you at the OSC to ask for a similar level of disclosure for brokerage fees. Let's get this in motion.
© 2007 The Globe and Mail. All rights reserved.
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