Weekly Insight

How to get the skinny on your fund's fat fees

Tuesday, May 27, 2008

How fat are your funds?

Let's find out using a measure called the Fund Fee Index. It's loosely based on the Body Mass Index, which is widely used to determine whether people are carrying too much body fat. A BMI reading above certain levels suggests excessive weight or, ultimately, obesity. With the Fund Fee Index, high readings warn of weighty fees in mutual funds and exchange-traded funds.

The BMI compares weight to height, which means it puts the body fat issue into some kind of context. The Fund Fee Index does much the same thing by evaluating the fees investors pay to own a fund in relation to the returns they receive.

With the Fund Fee Index, you want the lowest scores you can get for your funds. Consider the most popular exchange-traded fund in Canada, the iShares Cdn LargeCap 60 Index Fund. It has an index score of 0.9, which tells you that just 0.9 per cent of its gross returns over the past five years were clawed back to cover fees. Talk about slim and trim.

Want to know what a well-fed Fund Fee Index score looks like? Then your attention is drawn to the most popular of all mutual funds in Canada, Investors Dividend. The Fund Fee Index score here is 24.8, which tells us that fees ate up almost one-quarter of the gross returns made by this fund over the past five years.

Whether you own ETFs, which are index funds that trade like a stock, or mutual funds, where you benefit from the expertise of a professional money manager, fees must be paid on an ongoing basis. That's fair - the investment industry is a business, not a charitable institution.

Still, it's the responsibility of investors and advisers to make sure that paying fees brings good value in the form of returns. This is where the Fund Fee Index comes in.

It should be noted that the index isn't a straight measure of how much people pay to own mutual funds. For that, you want the management expense ratio, or MER, which measures almost all costs of owning a particular fund as a percentage of its assets. What the Fund Fee Index does show is how a fund's MER compares with its returns, just as the BMI balances your weight against your height. It's all about getting an answer to the question of whether your funds are too weighed down by the fees they charge.

Here are a few quick observations from running Fund Fee Index numbers for some of the country's biggest mutual funds and exchange-traded funds.

1. ETFs are the picture of svelteness in terms of their fees.

2. It's pointless to generalize about the value that investors get for the mutual fund fees they pay - some funds are outstanding, many are middling and some are pretty bad.

3. Dividend funds are one of the better-looking categories, according to the Fund Fee Index, while money market funds are among the worst.

The dominance of ETFs relates to the fact that they mainly hold the same stocks or bonds as a particular index, which means they're easy to run and thus have low fees. Mutual funds, which employ teams of managers and analysts to help identify the right stocks and bonds, cost more to run and thus more to own.

Keep in mind here that the cost of owning both mutual funds and ETFs is invisibly sliced off the top of their gross returns. When you see a published return for either type of fund, it's an after-fee number. If you can't see the fees you're paying, it's hard to judge the value you're receiving.

Enter the Fund Fee Index, which admittedly is a little bit technical. It's calculated by adding a fund's MER to its five-year compound average annual return to get a gross return. Next, you divide the gross return into the MER and multiply by 100. The final result tells you how much body fat your funds are carrying.

To build a database for comparing ETFs and mutual funds, Fund Fee Index scores were calculated for the 50 most popular mutual funds of all types, and for the 12 ETFs that have a five-year record. The best index score for a mutual fund was the 8.7 earned by the Phillips Hager & North Dividend Income. The worst score on the ETF side was the iShares Cdn Short Bond Index Fund at 4.8.

Here, we have a vivid example of how the low fees of ETFs work to the advantage of investors. The ETF scoring worst on the Fund Fee Index beat the mutual fund with the best score.

This isn't the most pristinely fair comparison, mind you. A good chunk of the fees charged by most mutual funds go not to fund companies, but to investment advisers as compensation for service provided to fund-buying clients. ETFs for the most part include no such fees. Another complication is that ETFs trade like stocks, which means there are brokerage commissions to buy and sell them. Increasingly, mutual funds are available with minimal buy and sell fees, or no fees of this type at all. On the whole, though, it's fair to say that ETFs are less weighed down by fees.

Among mutual funds, dividend funds appear to be the category that offers the best value for fees. The credit goes to their combination of low fees and good five-year returns.

Money market funds have an obesity problem thanks to fees that are very high in relation to returns. Exceptions here are the premium money market funds offered by the big banks for clients with large amounts to invest ($100,000 at least, and sometimes more). The very low MERs of these funds help improve the Fund Fee Index score a lot.

It's important to note that while a low index score is often a function of a fund's cheap MER, it can also reflect the impact of knock-out returns. TD Canadian Equity has a middling management expense ratio of 2.09 per cent and a laudable Fund Fee Index score of 8.8. How come? This fund made 21.7 per cent annually for the five years to April 30, which is stellar.

In much the same way, funds with middling fees can have unsightly Fund Fee Index scores if their returns have been weak. RBC U.S. Equity's Fund Fee Index score is 34.1, which comes from the way its MER of 2.02 per cent compares with its five-year average annual return of 3.9 per cent.

For the most part, a low Fund Fee Index score tells you that a fund is well priced in terms of the returns it delivers. A high score is a sign of a fund with fat fees.

Weighing in on fund fees

Introducing a new way to measure the value you get from the fees you pay to own mutual funds and exchange-traded funds.It's called the Fund Fee Index and it illustrates the extent to which fees are weighing down the returns from a fund. The lower the Fund Fee Index score, the better for investors.

The top 12 most popular mutual funds

The five lowest-scoring funds in the Top 50 by assets (that's good)*

*excluding money market funds

The 12 most established ETFs

The five highest-scoring funds in the Top 50 by assets (that's bad)*

How to see where your funds stand on the Fund Fee Index: Take the published five-year average annual return and add the management expense ratio to get the gross return. Then, divide this number into the MER and multiply by 100. The resulting number tells you what percentage of your fund's gross returns have gone to cover fees.

This article first appeared on GlobeinvestorGOLD.com. If you'd like to profit from the insight of more than 30 financial experts and columnists, including this columnist — sign up for a free trial to GlobeinvestorGOLD.com.

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