As investing fees bite, make sure there’s a slice of profit left

ROB CARRICK | Columnist profile | E-mail
From Tuesday’s Globe and Mail
Published Monday, Feb. 27, 2012 6:10PM EST
Last updated Tuesday, Feb. 28, 2012 8:42AM EST

Be a friend to the investment industry. Stay ignorant about fees.

Mutual fund companies and other investment firms certainly hope you do because they could soon be confronted by the greatest fee challenge they have ever faced. Returns from both bonds and stocks could be disappointingly low in the years ahead and, after fees, there may not be a lot left over for investors.

The case for low stock market returns was succinctly made in a recent article by Samuel Lee, an analyst with the independent research firm Morningstar. I featured the article in my daily blog, The Reader, because its thesis seems so plausible. Basically, Mr. Lee argues that what he describes as a “deleveraging process” – a slowing of the economy caused by a gradual paying down of personal and government debts – may limit stock market gains to 4 or 5 per cent for the next several years.

That’s a U.S. perspective, but it’s relevant here as well. Canada is not swamped by debt like the United States is, but our deficit is still large enough that the upcoming federal budget should be the toughest in ages. Individual Canadians have pretty much the same debt levels now as Americans did before their housing market crashed. It’s not hard to imagine a period of household austerity ahead as these debts are paid down.

As for the U.S. economy, Mr. Lee said the two best analogies for what’s ahead are the latter half of the Great Depression and Japan’s lost decade. In that light, he argues, then U.S. stocks today look “worryingly overvalued.”

Your stock market returns could well be on the low side in an economically tepid environment of low corporate profit growth, but your mutual fund fees won’t be. The average Canadian equity mutual fund’s management expense ratio is 2.45 per cent. Prefer to focus on the most popular funds? The average MER for the 10 most widely held funds in this category is 2.1 per cent. If we get 4 to 5 per cent stock market returns as Mr. Lee suggests, then you could be in a position of seeing your returns halved by fees.

Now, let’s look at bonds. Interest rates are already near historical lows and there’s not much room for further declines. Rates moving lower is what drives big price gains for bond funds. With stable rates, you collect the usual interest payments on the bonds in the bond fund and maybe a little more if you have a smart fund manager. If rates rise, your bond fund would probably lose money.

The outlook is for today’s low rates to stick around a while, which suggests bond fund returns will largely reflect the interest rate on bonds. Let’s see now – the five-year Government of Canada bond yields about 1.3 per cent, and a five-year bond issued by a financially solid company might get you between 2 and 3 per cent. Meanwhile, the average Canadian bond fund MER is 1.72 per cent and the 10 largest funds in the category cost an average 1.5 per cent to own. So much for the yield on that five-year Canada bond. It’s going to be devoured by fund fees.

Do not count on the fund industry to lower fees if returns diminish, although this has happened in the past. Back in 2009, money market fund fees were chopped so that unitholders didn’t end up losing money. Interest rates had fallen and fees as they were at some firms would have more than offset the interest paid on the short-term securities held by money market funds. The industry would have had a massive scandal on its hands if money market funds, a supposed haven, were allowed to sink into the red.

The lesson here is that mutual fund companies will cut fees only if absolutely necessary. That means it’s up to you to take care of yourself. One option is to join the slow but steady migration to exchange-traded funds, which in their classic form are index-tracking funds that trade like a stock. ETFs, with their low costs, are a more frugal alternative to funds for both do-it-yourself investors and those who use advisers.

But there’s no reason for cost-conscious investors to give up on mutual funds. Just remember to weigh two things when considering a fund – its fees and the possibility of low investment returns in the years ahead. Don’t be the ignorant investor who lets his mutual fund companies make out better than he does.

Carrick, Robb. “The Globe and Mail.” Home. The Globe and Mail, 27 Feb. 2012. Web. 01 Mar. 2012. .

Do you know what your investments cost? You would think that the collapse of worldwide markets would have provided a wake-up call to both governments and investors, but that’s not the case.

As a Portfolio Manager for private wealth individuals in Canada, I come across many intelligent and sophisticated individuals who have little, if any clue as to their all-in management fees with their current adviser. Truth be told, you’d probably need a forensic accountant to discover how much your investment adviser really earns from managing your money.

The problem is that all-in fee structures are just not transparent, and the Canadian government (unlike other governments in the UK, U.S, Australia) has shown little interest in forcing the industry to simplify its communication of management fees.

The reality is that very few Canadians realize just how much degradation occurs within their investment portfolios as a result of profits being siphoned out via “management”, “trading”, and “trailer” fees into the hands of financial advisers and the financial institutions that they work for.

The biggest culprit of portfolio degradation is the Canadian mutual fund industry itself. Mutual funds became popular in the 60’s and 70’s as investors realized that they could access and tap into professional portfolio managers via a pooled set of funds.

Admittedly, the concept was a good one. The problem today is that financial institutions have bastardized the concept. Thanks to the large fees attached to most mutual funds, investors are almost guaranteed to under perform the market, while bearing most of the downside risk. Meanwhile the mutual fund companies rake in their profits regardless.

Mutual funds are not the only ones offering fees that are out of proportion to the value of services received.

Many high net worth investors turn to professional investment managers for tailor made, customized investment solutions. Under this scenario, investors will often pay an investment fee to the firm. One immediate tax advantage that private wealth firms have over mutual funds is that investment management fees are tax deductible whereas mutual fund management fees are not. The “tax deductible” feature enables high net worth individuals who use portfolio managers, to presumably get better quality and service at lower costs.

These are difficult times for private wealth management firms, more so with the larger ones, as they have high operating costs and large overhead to maintain. A sharp depreciation in the value of portfolios and a migration of assets from high-margin products to the safety of deposits, money market products and government bonds, has eroded profits for many of these large firms.

Leave it to the financial services industry though to figure out innovative ways to disguise higher fee structures and market ill conceived products.

At many large firms, an incentive exists for wealth managers to churn accounts in order to generate trading fees and commissions. These commissions often serve as a drag on the portfolio and directly convert client principal into fees and commissions for the broker and firm.

Higher trading commissions are often overlooked and downplayed by private wealth firms as simply small, immaterial costs within a ‘Buy and Hold’ portfolio. Make no mistake, high trading fees eat into profits over the long run. Furthermore, it compels portfolio managers to take a “Buy and Hold” philosophy even if the situation does not call for it. It is difficult enough for a portfolio manager to slim positions when the market is in free fall, but it’s that much tougher of a decision if he knows that the account will be further eroded by trading fees. Thus, clients are often left holding the bag much longer on poor performing stocks.

“Proprietary” or “Structured” products have become the next step in the evolution of financial offerings. Most of these are marketed by large financial institutions under the veil that an investor can somehow get the best of all worlds. In truth, these products represent one more way for financial institutions to surreptitiously filter money out of the hands of investors and into their pockets.

The Globe and Mail (”Why Investors Can’t Have It Both Ways” By John Heinzl) recently exposed one such structure product marketed by the Bank Of Montreal,called the BMO Blue Chip GIC. The bank marketed the GIC as a low risk investment with the potential for large rewards — basically, a “too good to be true” offer. In fact, by the time, you go through all the fine print, an investor, in all likelihood is guaranteed to generate very low returns. The probability of there being some significant upside was highly remote yet the marketing materials clearly focused on the absolute best case scenario.

Structured products have become so bad that the Securities Exchange Committee (SEC) in the U.S. has launched an investigation into financial institutions who have over charged individual investors for structured notes while failing to disclose fees, and potential conflicts of interest.

Unfortunately, we are unlikely to see a similar investigation here in Canada. If we have yet to tackle clear abuses within the mutual fund industry, it is apparent that there is little appetite by the government to pursue further misrepresentations within the marketplace.

When I walk into a casino, I know over time I am guaranteed to lose. Most Canadians know this too. What they don’t know is that the same applies to the Canadian financial industry.

Paying someone to invest your money in mutual funds is akin to paying someone to pump gas into your automobile. You used to do so years ago, but in this era, very few any longer see value added in doing so. In a large way, mutual funds have outlived much of their usefulness.

Mutual funds were more valuable to the investment community years ago when neither discount brokers nor exchange traded funds existed – not that mutual funds have ever been great investments.

The primary value of a mutual fund use to be that it provided diversification to the investor. But with the plethora of discount brokers in the market and trading fees that are in many cases as low as a penny per share, investors can often achieve their own diversification with less than $20,000 in their bank account.

Furthermore, do-it-yourself investors can now purchase index funds or something known as exchange traded funds (ETFs). With index funds, an investor will never beat the index but neither will the portfolio underperform.

In comparison, the vast majority of mutual funds (close to 80%) underperform their respective index. Not a surprise when you realize that a mutual fund has to outperform the index by at least its management fee. With average management fees in the 2.5%-3% range — that’s a whole lot of ground to make up. So, it should be no surprise that very few mutual funds do well over a 10 year period.

What does surprise me most about the mutual fund industry is just how successful they have been at integrating themselves. I cannot tell you the number of intelligent and sophisticated individuals who have no idea what kind of fees they are paying on mutual funds held in their portfolio.

On the other hand, how surprise should I be especially when the industry is able to keep fees hidden from the investor. Heck, most investors don’t even realize that a “trailer” fee (aka: kickback) is given to the salesperson.

As an investor, you want the most direct path to the individual who is doing the actual investing, which is likely to be a portfolio manager with a passion for the markets, not an agent who sells funds, who’s passion is for asset gathering and sales. I acknowledge they are excellent salespeople, and very smooth. They will often have a glib and sardonic response to everything I have mentioned.

If you have made the decision to invest in mutual funds, you should only do so with exchange traded funds. The banks can help you set up a self-directed brokerage account where you can easily buy and sell these funds yourself. Unless you have a penchant for paying fees, please do not use a bank advisor to purchase mutual funds for you.