Monday, January 9, 2012

Part Two: Why Mutaul Funds are like Popcorn.....Explaining The Fee Gap

Mutual Fund Fees: Part Two     
In part one we discussed the position put forward by Fund Companies and Advisor/salespeople that the Management Expense Ratios in Canada represent fair value for investors. The logic they use does not hold water when you break down the component parts of the MER between investment management, sales channel expense, and the “advise” component.  As we showed in the previous blog, the portion that is reasonably assigned to “advice” seems to be far too high. In an efficient world we have shown that a typical Canadian Mutual Fund with an MER of 2.4% per year would have approximately 1.2% available to cover the advice cost. In fact, the fund companies generally pay a “trailer fee” to sales people to cover the cost of the annual advice component of the fee. That trailer can vary between 0.5% and 1% per year. This would suggest an average advice fee of .75%. This suggests that there is another fee component that we are not accounting for?
Formula: MER = investment management expense + sales channel expense + advice fee + ?
                2.4%= .7% + .5% + .75% +?
                ? = 2.4% -.7% -.5% - .75% = 0.45%
Where does the mysterious 0.45% go? In fact, on the typical mutual fund with a 0.5% trailer the mysterious “?” factor is 0.95%. In effect, we can surmise that Canadians are paying an extra half to one per cent on mutual funds after all reasonable fees have been accounted for. Who gets the extra fee?
Alternative Scenario: Mutual Funds in Canada are priced to reflect what an uninformed investor can be convinced to pay. The mutual fund industry and the “advisor” industry have set up an ideal world for the exploitation of investors. The key components are as follows:
Ø  A closed market where prices can be set by a few large companies.
Ø  Self regulatory oversight where the same companies can dominate the rule making process
Ø  A sales channel that can act to keep the investor unaware of low cost alternatives
Ø  An uninformed Government that can be manipulated to support the ongoing deception
For those that think this is about a big “conspiracy theory”, let me assure you it is not. Conspiracies are too complex and the details would eventually leak out. Instead this is about a combination of ignorance, laziness, and business strategy.
Ignorance & Laziness:  Most of us slowly and almost unwittingly enter the world of investing. Our first investment need is often an RRSP or TFSA account. Investors are typically directed to their bank or “advisor” to teach them how to manage their investments.  Often young adults will learn important skills from their parents; however the financial world has changed so fast that we do not have a pool of knowledgeable parents to educate the young investors. The educational system does not teach money management and, in truth, most investors are unaware of the problems and thus of the need to become educated. Investors are focused on their jobs, family, and day to day life. The path of least resistance is to be a part of the current system and use the bank or fund company sales channel. This is a combination of laziness ( not getting ourselves educated about investing) and ignorance (not knowing the current process is a problem).
Governments are also a part of the ignorance problem. Rather than regulating the investment process the governments have chosen to allow the industries to regulate their selves. These “SRO’s” include the Investment Funds Institute of Canada (IFIC) and the Investment Dealers Association “IDA” whom have morphed the regulatory duties into the Investment Regulatory Organization of Canada (IIROC). In short, those who profit the most from unfair fees are the group the government allows to set their own rules and standards. The result of this has been a government who does not protect investors and who then actually looks to the industry SRO to provide guidance to the government on industry policy. An example of this collusion was the decision by the government of Ontario to exempt fund companies from disclosing the HST paid on mutual funds. The only possible purpose in doing so was to hide any information that could allow investors to determine their monthly fund fees. The government bought into the bizarre suggestion to exclude the information from statements and the industry benefits at the expense of the investor.

Currently we are seeing an even more egregious example of an industry run amok as the various levels of governments defer “investor education” programs to committees dominated by executives of financial firms who sell funds. Most people who understand the industry are left to shake their heads and mutter about the “wolf guarding the henhouse”. As for the government, they appear to be happy to defer to the industry in a way very similar to how the average investor defers to the mutual fund sales status quo. Governments are not being so much duplicitous as they are being ignorant and lazy. Why look for problems and solutions if investors are not making waves.
Business Strategy: The fund executives are in the business to make profits for investment firms who employ them. Period! They are not in the business of providing advice, education, or regulatory oversight. Their business strategy, however, necessitates that they control the advice, education and regulatory processes that impact the fund industry. Their strategy has been to control the process from start to finish and create a closed loop.  The industry controls the production of funds, the regulatory oversight, the distribution of funds, investor education, provides guidance on government policy decisions and sets the pricing of all services to the investor. It is a great business model and one that generates massive surplus profits for the fund industry.
On the Street Impact: The impact of the strategy is felt directly by the investor. While most investors are not aware of the strategy they are very aware of the impact it has had on investors.
-          Canadians pay the highest fund fees in the world
-          Canadians deal with “advisors” who are in fact licensed sales people and have no legal duty to put the client’s interests before their own. In actual practice advisor/salespeople clearly prioritize their own benefits ahead of their clients. For proof look only as far as the next point.
-          Over 80% of mutual fund sales people are NOT LICENSED to sell competing products such as low cost index funds that trade on the TSX. These funds are amongst the top performing funds every year and cost as little as a tenth of the cost of equivalent mutual funds.
-          Canadians buy a significant portion of their mutual funds with deferred sales charges. These charges are being banned in a number of countries (Britain, Australia) and are rarely sold in the U.S. where investors are much quicker to sue an advisor over improper advice. These fees are designed to lock an investor into a single mutual fund company for up to seven years with little or no corresponding benefit to the investor.
-          Canadians have no binding complaint process that allows for arbitration of investor complaints with multi-billion dollar financial firms. If a firm does not pay up the individual investor faces the daunting task of suing a firm that has the top securities lawyers on speed dial.
-          Canadian mutual fund statements and disclosures are amongst the worst in the world. Investors are not provided with monthly cost of fund fees, personal rates of investment return, nor proper benchmarking information.
-          Risk ranking of various mutual funds has been left to each individual fund company. In fact, the same fund can be rated at a different risk level by two different distributors at the same time. The acceptable risk rankings have no basis in quantitative analysis and thus are at best useless and at worst dangerous.
The above are only a few of the negative impacts we can attribute to the business strategy of Canada’s large fund firms. However, as any fund executive will tell’s not personal, it’s just business!
As Canadians struggle to build their retirement nest eggs it should be clear that at least part of the problem for investors is the significant skimming of retirement funds by mutual fund companies and so-called advisers. In the real world the cost of the additional and excessive fund fee is reflected in delayed retirements, eroding retirement portfolios, improper retirement planning advice, and a general sense that the average Canadian cannot seem to get ahead.
Perhaps this is part of the issues that pushed some people to Occupy Wall Street! Add in the bank strategies on increasing consumer debt, excessive credit card fees, excessive chequing account fees and you begin to see a pattern of skimming that leaves the 99% with little to cover basic living expenses. Of course ignorance and laziness are somewhat self induced so we can solve these issues ourselves. However the solution will have to start at the ballot box because currently the fund firms hold all the trump cards!
Wow, that sounded more political than I intended! This blog does not take political stands but fortunately (or unfortunately in this case) all political parties currently bow to the financial firms with equal deference.
Sois mike

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