What factors influence returns?

Net returns consist of several key components that should be evaluated based on their combined effect on an investment. But a tax-sensitive client, for instance, may concentrate on investments offering enhanced tax efficiency, without taking into account their higher fees and expenses. The strategy is appealing when viewed through the lens of taxation, but after factoring all components of net returns, it may mean paying an additional dollar in fees and expenses to save 75 cents in tax.

Similarly, an investor concerned about management expense ratios (MERs) might choose an index fund or ETF while overlooking how other components affect net returns.

The table below details three categories of net return components: asset allocation, fund level, and investor level.

Table 1: Components of Net Returns by Category

Asset Allocation	+ Market Exposure	Allocation to equity versus fixed income
	+ Dimensions of Expected Returns within Equities	Exposure to company size, relative priceand profitability
	+ Dimensions of Expected Returns within Fixed Income	Exposure to term and credit
Fund Level	+ Securities Lending Revenue	Revenue from lending securities net of portionpaid to the lending agent
	– Fees and Expenses	Management Expense Ratio (MER)
	– Explicit Trading Costs	Trading Expense Ratio (TER)
	– Implicit Trading Costs	Bid/ask spreads and market impacts
	– Cash Drag	Reduced expected return from allocation to cash
	– Withholding Taxes	Applied to foreign dividends (may or may not be fully or partially recoverable via foreign tax credit)
InvestorLevel	– Taxes	› Taxes on distributions: income, capital gains,and dividends › Taxes on capital gains from redemptions › Foreign withholding taxes on dividends frominvestment vehicles domiciled outside of Canada(e.g., U.S.-listed ETFs)
	– Investment Vehicle	Commissions, bid/ask spreads, premiums/discounts to NAV

Asset allocation

The first three components—market exposure, equity dimensions and fixed-income dimensions—relate to asset allocation and the corresponding risk/return trade-offs clients make with respect to their unique goals, risk preferences and time horizon. Available research suggests the dimensions of expected returns within equities (market, company size, relative price and, more recently, profitability) and fixed income (term and credit) are the primary determinants of a portfolio’s gross expected return. It’s important to consider how the investment strategy attempts to capture the return premiums from these dimensions, if at all.

Fund-level components

These can impact a fund’s NAV and reported return by increasing revenues or incurring higher costs.

Securities lending

Lending securities is a lesser-known way of adding value beyond the performance of the underlying holdings. The added return depends on the securities in the fund, the type of collateral and the execution of the lending program. Fund revenue goes up with an increase in the utilization rate (i.e., portion of the fund on loan), a higher fund portion of the revenue split with the lending agent, and larger spreads (collateral investment rate minus the rebate rate paid to the borrower). Typically, a fund holding a larger percentage of securities in high demand, known as “specials,” can achieve larger spreads and higher utilization rates. Revenue from securities lending is reported in a fund’s financial statements. It does not reduce the reported MER of a fund, but it can increase returns to investors. (Revenue from securities lending isn’t guaranteed.)

Fees and expenses

The MER quantifies management fees and fund operating expenses, and is expressed as an annualized percentage of average net assets. This cost is a significant component of net returns, and rightfully receives a lot of attention. It’s preferable for a fund to charge a low management fee and have low operating expenses.

Operating expenses are charged to a fund in two ways. The first is where the costs flow through to the funds so that investors pay actual costs incurred up to a maximum limit, if applicable. This incentivizes the manager to reduce costs wherever possible (e.g., due to economies of scale). However, operating costs aren’t known until the fund’s financial statements and management report of fund performance (MRFP) are available. In contrast, some fund managers charge a fixed administration fee to the funds (disclosed in the prospectus) so that operating costs are known in advance. The fee can exceed the actual cost of the services and provide an additional source of revenue to the manager, in which case a manager may have less incentive to reduce operating expenses.

Explicit trading costs

A fund’s net return also depends on how much it trades, measured by turnover. Explicit trading costs are not reflected in the MER, and include commissions paid to buy and sell securities, and possibly exchange fees, stamp duties and other taxes, depending on the market. The trading expense ratio (TER) quantifies total commissions paid and is expressed as an annualized percentage of average net assets.

Implicit trading costs

Implicit trading costs result from market frictions and typically are of a greater order of magnitude than explicit trading costs, particularly when the trader requires immediacy. Seeking liquidity moves prices and increases trading costs. Generally, the higher the immediacy and quantity needed to execute, the higher the price paid.

At the very least, a liquidity seeker will pay the bid-ask spread. More importantly, in addition to incurring the costs of that spread, demanding liquidity will often move prices, resulting in even higher implicit trading costs. Conventional and index investment approaches often require immediacy in their trades because the manager has a view about future prices or must satisfy a low tracking-error constraint.

Unfortunately, implicit costs are neither disclosed, nor easily quantifiable, nor readily available. The costs are embedded in the returns of the fund as a result of the increased price paid for securities or the decreased price received for securities.

Cash drag

If we define a cost as something that reduces the expected return of a portfolio, then a frequently overlooked cost is the potential drag on performance from holding cash or cash equivalents. The expected return on cash is modestly positive, albeit currently close to zero, whereas the expected return on a higher-risk asset class, such as equities, is substantially positive. If, for example, the difference in the expected returns on cash and a portfolio of riskier assets is 6%, and a fund holds an average 5% in cash, the cash drag or reduction in expected returns is 30 basis points.

Managers hold cash for various reasons. Their view of future security prices may lead them to attempt market timing that results in a sizeable cash position. Regardless of their view, they might also maintain higher cash balances to meet redemptions if the fund has frequent and sizeable cash outflows.

Foreign withholding taxes

Dividends received from non-Canadian investments are usually subject to foreign withholding taxes. This reduces the fund’s reported return because the tax comes out of NAV.

Foreign withholding taxes can become more onerous and opaque when a U.S. entity stands between a Canadian-domiciled fund and non-U.S. securities. For example, when a Canadian-listed ETF or a Canadian-domiciled mutual fund invests in a U.S.-listed ETF that holds non-U.S. securities, there is tax withheld on dividend payments from the underlying securities to the U.S.-listed ETF. There may be additional tax withheld on dividend payments from the U.S.-listed ETF to the Canadian-listed ETF or mutual fund.

Moreover, the additional withholding tax cannot be recovered via foreign tax credit. If the extra level of withholding tax applies, the additional tax drag will depend on the dividend yield of the underlying portfolio and the withholding tax rate charged.

Investor-level costs

These costs reduce net returns to the investor, but not the fund’s reported return, since they don’t come out of the fund’s NAV.

Taxes

Taxes on capital gains from redemptions, as well as on distributions of capital gains, interest and foreign and Canadian dividends, reduce net returns. Some structures propose to reduce or eliminate these distributions. However, a reduction in distributions ultimately corresponds to an increase in capital gains on redemptions. In this case, while the advantage is sometimes interpreted as a reduction in tax, it’s actually a deferral. The benefit may not be the amount of tax saved, but the time value of money on tax deferred. The economic benefit from the tax treatment of these structures should not only be quantified accurately, but also weighed against other components of net returns.

Foreign withholding taxes applied at the client level can also become more burdensome when a U.S. entity stands between the client and non-U.S. securities. A common example is when Canadian clients buy U.S.-listed ETFs that hold non-U.S. securities. A first level of tax is withheld on dividend payments from the underlying securities to the U.S.-listed ETF; a second level is withheld on dividend payments from the U.S.-listed ETF to a taxable Canadian investor.

The second level is substantially, if not completely, offset by a reduction in Canadian taxes via foreign tax credit; but the first level is not.

Investment vehicle costs

There may be additional implicit and explicit costs to trade the investment. ETFs trade on an exchange like stocks. In some cases, commissions are charged when buying and selling the ETF, which don’t apply to mutual funds. In all cases, the implicit cost of bid/ask spreads applies to buying and selling an ETF.

by Brad Steiman, director, head of Canadian Financial Advisor Services, and vicepresident of Dimensional Fund Advisors Canada ULC. brad.steiman@dimensional.com