Fund governance affecting performance: study

With the markets wreaking havoc on clients’ accounts, fees based on assets may seem like adding insult to injury for some investors. Two university researchers say it’s time we look at how Canadian mutual fund fees are determined, and whether a change in fund governance could result in lower costs.

Fees have long been the target for detractors of active management. According to Brock University professor of accounting Samir Trabelsi and his colleague Laurence He, professor of finance, only 5% of mutual funds beat their benchmark, after fees. Over a five-year time horizon, only 8.4% of Canadian equity funds beat their benchmark according to data from Standard & Poors.

Trabelsi and He say, in order for active management to be viable in Canada, fees should come down. They contend that mutual fund fees in Canada are the highest in the world at an average of 2.56%, compared to a global average of 1.29% and an average of 1.11% in the U.S.

“What the process is for setting fees remains undercover. They are not disclosed — the fund’s management set the fee themselves without letting the investors know,” says He. “The results are clear. If we compare Canadian mutual fund fees amongst other developed countries, we have the highest in the world.”

Trabelsi and He say, for an actively managed Canadian fund to yield the same return as its benchmark for a ten-year holding period, a fund must beat the index by an annualized return of 200 to 300 basis points. Managers who can do this are a rarity, meaning that investors will attain better value using passive products like ETFs or by using F-class funds, which have an MER more in line with American fund fees.

Trabelsi and He believe that an overhaul of active fund governance structure could bring fees down and make funds a better choice for investors. Currently they are trying to secure research money to explore how governance on mutual funds could be approved to make them more investor friendly.

“We are recommending a study of board composition and board characteristics,” Trabelsi says. “How does the board make decisions on these fees? We also want to know, how does the board assess mutual fund manager performance? How frequently does the board meet to discuss and what are the formalities for these boards of directors?”

The two researchers suspect that if a comparative study were done of mutual fund governance in Canada and governance in other countries, there’s a good chance fees would come down.

One of the most glaring discrepancies, is that, unlike in the U.S., mutual funds in Canada are not required to have independent boards of directors. Instead, they appoint an Independent Review Committee (IRC) that Trabelsi and He say has a narrow role of reviewing conflicts of interest. IRCs do not deal with the crucial issue of the setup of the fund management fees.

Also, in the U.S., fund companies must disclose the amount of fees paid for distribution — the 12b-1 fee. No similar requirement exists in Canada, so investors have little idea as to why they are paying the fees they are.

The U.S. Securities Exchange Commission has also adopted a new rule requiring fund boards to have at least 75% independent directors and an independent chair person. Trabelsi and He say directors for most Canadian funds are comprised of people from within the company.

“In Canada, mutual funds have an advisory board. It’s on a voluntary basis and there is rarely anybody sitting on the board ensuring the investors benefit. The manager will set the fees at their own discretion without consulting anybody outside the advisor,” says He. “Basically they play a very weak role because they do not have any voting rights.”

Trabelsi notes Canadian investors would be well served to have a board mainly comprised of independent directors with a good knowledge of not only the local mutual fund industry, but global industry practices. Perhaps even more important, board members should have their own money in the fund, so they have a vested interest in its performance and can provide de facto investor oversight.

“An ideal board would be comprised of people that have knowledge of the mutual fund industry, and they have a global perspective of the mutual fund industry,” Trabelsi says. “Research has shown that when a board of directors has its own money in the fund, those funds tend to outperform.”

Trabelsi stresses that a fund governance overhaul would likely not solve all the pricing issues in the Canadian marketplace. There are other issues at work, such as institutional, regulatory and tax pressures that influence the fee of a fund.

“Governance is not the only reason Canadian fund fees are higher,” Trabelsi says. “We do believe part of the reason is governance.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(10/09/08)