What do your funds really cost?
There has been a great deal of discussion in the business media over the past couple of years about the management expense ratios (MERs) of Canadian mutual funds. A fund’s MER represents its total cost to operate as a percentage of assets under management. It includes the management fees, operating expenses, and taxes paid by a fund over a fiscal year.
A recent study concluded that the MERs of Canadian mutual funds are among the highest in the world. The finding was disputed by the Investment Funds Institute of Canada (IFIC), not surprisingly since one of its roles is as a fund industry lobby group. But despite what IFIC says, it appears that the criticism is starting to have an effect on investment decisions. Although mutual funds are experiencing strong sales at present, they have been losing market share to low-cost exchange-traded funds (ETFs) in recent years.
Some fund companies have responded by introducing modest MER reductions. Others have launched new classes of units with lower MERs. One example of the latter is the new D series from RBC Funds which are being heavily promoted on radio.
The new units are only available to people with an RBC Direct Investing account. They offer a differential of as much as 75 basis points on management fees compared to the company’s regular units. The savings are a result of reduced trailer fees – annual commissions paid to a broker or dealer for services provided for as long as you own your units. They have not been completely eliminated – RBC Direct Investing still receives a small trailer. But the difference is significant.
RBC can’t publish actual MERs on the new units because they have not been in existence for a year. But to give you some examples, the management fee on Canadian and U.S. equity funds is only 1 per cent, compared to 1.75 per cent on the regular A units. For Canadian fixed-income funds, the difference is 50 basis points, with the fee dropped from 1.25 per cent to 0.75 per cent. These savings will flow right through to your bottom line return.
The catch is that you must maintain a minimum balance of $10,000 per fund in order to qualify for the D units. RBC is offering this option on a total of 43 funds.
The new D units are similar in concept to TD Asset Management’s e units. However, the latter can only be purchased on-line while the D units can also be ordered by phone.
If you have an RBC DI account, you should consider switching any existing positions in RBC funds into these new units, as long as you can meet the minimum investment requirements.
So just how much of an impact does a lower MER have? For a dramatic example, look at the relative performance of A-class and F-class units of bond funds in recent years. The A units are a fund’s generic brand (sometimes the letter designation is different but the concept is the same). F units are those sold to fee-based accounts. They have a much lower MER because the broker or dealer receives no trailer fees however the investor pays an annual fee for services, usually expressed as a percentage of assets under management.
Bond funds provide a good way to see the impact of these fees at work because of their relatively low returns. The A and F units of Franklin Templeton’s Bissett Bond Fund are a good illustration. Between 2004 and 2006, the A units finished in the second quartile of the Canadian Bond category twice and in the third quartile (below average) once. By contrast, the low-MER F units were in the top quartile twice and the second quartile once. In each year, they were one quartile higher than the A units (which, remember, hold the same assets). The pattern continued through the first half of 2007.
The A units have an MER of 1.44 per cent. Their three-year average annual compound rate of return to June 30 was 3.69 per cent. The MER of the F units is 0.80 per cent. Their three-year average annual return was 4.36 per cent, a difference of 67 basis points. Interestingly, the gain to investors did not match the reduction in the MER which, in theory, it should have. Still, they came out well ahead – or so it seems.
But here’s the problem. The return on the F units does not reflect the account fee paid to the advisor. In this case, if that fee exceeded 67 basis points (0.67 per cent), which it almost certainly would have, the net return to investors was less than if they had been able to acquire front-end load A units with zero commission in a regular account. That’s an option that is being offered by an increasing number of advisors. So don’t be pressured into switching to a fee-based account on the basis of the “no commission, low fee” sales pitch. Take a close look at all the options first.
The bottom line is that while reduced MERs can make a significant difference to bottom-line returns, they cannot be viewed in isolation. Consider all the expenses involved in owning units in a particular mutual fund or ETF – sales commissions, MERs, and account fees – and then decide which purchase option is the most cost-effective.
Adapted from an article that originally appeared in Mutual Funds Update, a monthly newsletter that provides advice on fund selection and strategies. For subscription information: http://www.buildingwealth.ca/promotion/50plusproducts.htm