Fund study blames advisors on fees

Just as the client calls about market losses are tapering off, advisors may soon face a brand new onslaught of angry calls, thanks to a study from the U.S. which is bound to gain traction in the mainstream press.

Canadian mutual fund investors are fairly well protected, according to a study of funds in 16 countries, conducted by the Chicago-based Morningstar Inc., and overall the industry scored a B-. But the industry is not likely to appreciate the report, which attacks the costs associated with funds.

In fact, most of the praise for the Canadian system is focused on the regulatory regime. Canada scored high in investor protection and transparency (in both the prospectus and reports segment, and in sales and media). But the report hammered the Canadian mutual fund industry on fees and expenses, giving it the only F in this category.

“Canadian investors do not pay much attention to fees,” reads the Morningstar Global Fund Investor Experience. “Canadian investors are comfortable with the fees because they don’t know how low these fees should actually be.

“Canada’s failing grade in fees is the lowest grade received in any of the surveyed areas. Canada has notoriously high management expense ratios.”

The report lays much of the blame for this at the feet of advisors, saying that funds with higher trailer fees are pushed harder.

“Assets tend to flow into average- or higher-fee funds because Canadian investors use financial advisors to help them make decisions,” the report says. “Advisors direct client assets to funds that pay better trailers. And since the trailer is included in the MER, the result is that assets flow into higher-fee funds.”

The report found Canada was doing some things right on the fee front, but these laurels were largely a result of regulators dictating matters of transparency in disclosure.

“In our study we also found that the history of expense ratios is not disclosed to investors in most countries, the few exceptions being Canada, Netherlands, Italy, Singapore and the U.S., where past expense ratios are disclosed alongside the current number,” the report said. “We believe that the expense ratios for past years ought to be disclosed together with the current number so that investors can easily determine whether these figures have increased.”

Not surprisingly, the report has drawn criticism from the Investment Funds Institute of Canada, which says Morningstar has made the same methodological errors as past studies.”

“It seems that the cross-country comparison of fees in this study suffers from the same problems that have plagued previous studies,” says Dennis Yanchus, manager, statistics and research.

He points to cross-country differences in what fees are included in the MER, as many jurisdictions do not bundled legal costs and distribution fees with management fees.

The GST adds an additional layer of cost to the MER, and will grow for many investors as Ontario opts for harmonization. Contingency fees and performance fees also tend to be higher in other countries.

In funds-of-funds, some countries only require that the MER for the overall fund is posted, while in Canada fund-of-fund MERs must include the charge of the top fund as well as the fees charged by the underlying funds.

Overall, the report gave top marks to the U.S., which scored the only A among the 16 countries in the study. China ranked second with a B+, while Taiwan, Japan, the Netherlands and Italy each received a B rating. Canada placed seventh overall with the sole B-.

New Zealand ranked dead last with a near-failing grade of D-, making it slightly worse than Spain, which scored a D.

Five years ago, Morningstar launched Stewardship Grades in the United States that evaluate the degree to which fund companies put investors first,” said John Rekenthaler, vice-president of research for Morningstar. “These grades have been a catalyst for positive change in the fund industry. We hope our global study will expand the dialogue about best practices for the mutual fund investor to investment companies, distributors, and regulatory bodies around the world.”

Rekenthaler points out that there is far more interest in governance issues on the common stock shareholder level, which has sprouted a cottage industry in assessing governance quality. On the fund side, he says there isn’t even a “shack” industry, let alone a cottage industry.

For a full version of the report, please click here.

(05/12/09)