Friday, December 16, 2011

Why Mutual Funds are like Popcorn

 Why Mutual Funds are like Popcorn!

The Canadian mutual fund industry runs on the theory that Canadian investors will voluntarily pay annual fees to mutual fund salespeople in return for selling a mutual fund and providing advice. The main players in this business are a) the investor, b) the mutual fund company, and c) the salesperson.
The key to implementing this strategy has been to ensure that the investor is not provided with either a minimum service standard for the “advice” component nor a summary of the fees being paid for the “advice” service.

If we focus on the retail investor; the investor is paying an annual MER which covers everybody’s expenses and profits. In fact, the investor is the only source of money and the only person who is not guaranteed a profit every year. As such, we can conclude the embedded cost of the “advice” is equal to the fee paid by the investor less all expenses involved in fund manufacturing and sales.

Formula: Investor Cost is defined as: MER= manufacturing cost + sales cost + advice costs

The Advice: When fund companies talk about “advice” being provided they do not attempt to  explain why the advice would need to be facilitated through the fund company’s salesman. Since fund companies are not promoted as being in the business of providing advice, it would seem that the advice component would be a distraction from the core business of managing money. Fund companies do have expertise in managing investments and that is where they are most efficient. In many cases the fund company will outsource the “advice” component to an independent salesperson. These salespeople generally call themselves “financial planners” or “advisors”, although these titles mean nothing specific in terms of knowledge. The “advice” component is non-defined in terms of either quality or frequency of the advice investors should receive. As such the salesperson does not need to meet any standard for advice nor confirm any advice has been provided in order to collect the advice fee. In fact, the commission for providing the advice is often paid to the salesperson up front before any follow up advice service would be expected to take place.
COGS: Fund companies are in the manufacturing business. As such the fund companies are fully aware of the accounting term “COGS” or cost of goods sold. The COGS for a fund company is likely in the order of 0.4-0.5% based upon the wholesale pricing that is available. Some would argue the number is more likely between 0.2-0.4% but let’s assume the higher number to be conservative. Adding a margin for strong profits, the manufacturing company can thrive on a price of 0.7%. This is on the high side of the estimated cost range and provides a profit margin of 75%-100%.
 Having solved for what appears to be a generous but reasonable manufacturing cost, the formula can be updated as below:

Investor Costs (MER) = manufacturing cost + sales cost + advice cost

                                    = 0.7% + sales costs +advice costs

Sales: Mutual fund manufacturers also need to sell their product. The cost of the sales process varies based upon the sales channel(s) the company uses to distribute their funds. Some companies such as Steadyhand sell manufactured products directly to investors. As such, a large investor can achieve MERs as low as 0.77% for a Canadian equity fund and just below 1% on foreign equity funds. Steadyhand is not a manufacturer, but is a low cost distributor of custom funds they create through investment management firms who provide wholesale services to Steadyhand. Steadyhand does not utilize an “advisor” sales force, but handles sales via phone and internet which is lower cost and quite efficient.
Alternatively, bank mutual funds are sold by a “captive” sales channel. The bank’s employees are most often salaried and the salary cost is spread across multiple product lines. This sales channel is low cost and efficient as the banks’ leverage internet sales, discount brokerage sales and branch staff sales. TD bank offers a balanced mutual fund through its e-series for 1.28%. The e-series does not provide an advice component so the fee is comparable to Steadyhand. The Steadyhand pricing reflects a small focused sales channel approach, while TD represents a large multi-channel sales approach, neither of which is advice focused.
The combined manufacturing and sales channel costs for Steadyhand  are assumed to be mid way between the lowest Canadian and foreign equity MERs. Subtracting the 0.7% manufacturing cost leaves a sales channel cost of 0.14% ( 0.84 - 0.7 = 0.14%).  TD sales costs using the balanced fund as the average would be 0.58% (1.28-0.7= 0.58%). Let’s assume the sales channel expense of a fund company is on the higher end of the range provided by the two examples, and we can set sales channel expenses at 0.5%. Our formula now looks like this:
Investor Costs         = 0.7 + 0.5 + advice costs.
Given the average MER for Canadian equity funds is approximately 2.4%, the formula can be solved as follows:
Investor costs= manufacturing cost + sales cost + advice cost
2.4% = 0.7% + 0.5% +advice cost
Advice cost= 2.4% - 0.7% -0.5% = 1.2%
The advice component is thus valued at 1.2%. That is half the cost of a typical equity fund MER in Canada. In effect, if this is correct, fund companies are in the primary business of selling advice since it accounts for the largest component of their MER fee.
U.S. Comparison: If we were to use an example of typical U.S. mutual fund fees the formula appears to work reasonably well. Based upon an average MER of 1.4% for US equity mutual funds the formula looks like this:
Investor costs= manufacturing cost + sales cost + advice cost
1.4% = 0.7% + 0.5 % + 0.2%
The advice cost is 0.2% and the fund companies are definitely in the primary business of manufacturing and selling investment funds. If we assume U.S. funds have a lower cost environment and economies of scale, the advice component may be as high as 0.3%-0.4%, but it is still the smaller component of the various fees in our formula. Regarding economies of scale, the Canadian fund firms manage hundreds of billions of dollars in mutual funds yet the largest firms such as Investors Group have amongst the highest fees. This suggests economies of scale are not passed down the line by fund companies in Canada.
Popcorn Theory: A similar approach can be used to look at the movie theatre business. This comparison would provide a glimpse of what may be wrong with the conclusion that fund companies are really charging fees for “advice” as opposed to investment skills.
When my wife and I head to the theatre it is for the express purpose of seeing a movie. We understand the evening will cost a set amount of money and we are prepared to spend accordingly. We do not divide the cost of the event into “movie cost” and “snack costs”. We understand we will have popcorn, a soft drink and we will watch the movie and it will cost around $30.00 for the evening.
The theatre owner, however, does care how we spend our money. Movie theatres make extremely large profits from selling popcorn. Expenses in preparing popcorn are very low, popcorn profit margins are very high, and little skill is needed to train staff. The actual movies by contrast are expensive to make and thus  expensive for a theatre to purchase. Movies can be big winners or they can be expensive duds for the theatre owner. On the surface, it would appear the theatre owner would be better off if they focused on selling popcorn and not on the low margin movie component of the business. However, here is the catch: in real life nobody would travel to a theatre just to buy popcorn. The movie is the sizzle that creates the opportunity to sell the popcorn! Without the movie there is no opportunity to distribute the extremely profitable popcorn!
 Applying the popcorn theory to the investment business; few investors would buy mutual funds without the confidence they were getting valuable investment and planning advice. In essence, investors do not seek mutual funds, they seek advice!

 The fund companies know that the "advice" component attracts investors who otherwise would not purchase mutual funds. The "advice" performs the same function as the "movie" does.... it attracts clients who can then be sold a very profitable secondary product. In the case of investors, the very profitable secondary product is the mutual fund.
 Further proof that this comparison is correct is found in the high volume of expensive mutual funds sold with an advice commission, versus the much smaller sales volume of lower cost, direct sale mutual funds. Investors overpay for the mutual fund to get the perceived advice they are seeking.  The main difference is moviegoers know what the popcorn costs them while investors face a hidden "advice fee" buried in the MER costs.
In the next blog we will delve a little deeper into why the Canadian mutual fund fee model does not make sense and how that contributes to Canada's exorbitant mutual fund fees.

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