Fund analysts dismiss

(April 7, 2004) In its annual exercise in fee comparison, Barclays Global Investors Canada has declared April 12 to be fee-freedom day for mutual fund investors. The firm, one of Canada’s primary managers of exchange-traded funds (ETFs), points out investors in its low-fee products were “fee free” by January 13.

“Fee freedom day is the day in the year that Canadian mutual fund investors stop paying their managers and start paying themselves — keeping the returns that their savings generate,” said Howard Atkinson, head of public funds at Barclays.

Last year Barclays declared July 28 to be fee freedom day and the firm acknowledges that April 12 is a substantial improvement. But Atkinson says this is due to better returns and not lower management fees.

“In fact, the median Canadian equity mutual fund management expense ration (MER) actually increased year-over-year,” he says.

So how does the Barclays arrive at this date?

“To determine fee freedom day, we express the MER for mutual funds in the Canadian equity asset category as a percentage of median, pre-MER five-year annual returns for that category — based on year-end 2003 data provided by Globefund,” Atkinson explains. “We then apply that percentage to the days in the year to arrive at the specific date for fee freedom day. The Canadian equity mutual fund category is probably the one that Canadians focus on most.”

The company offers the following formula:

MER/(MER + RET) x 366

Where:

MER = the median annual MER of mutual funds in the Canadian equity asset class, as of year-end 2003 (2.7%)

RET = the median five-year annual return, after expenses, of mutual funds in the Canadian equity asset class as of year-end 2003 (6.99%)

“While MERs are certainly something that all fund investors should consider, the methods used to calculate so-called fee freedom day are really a marketing department creation, rather than a type of measure that would be used by independent fund analysts,” says Rudy Luukko, investment funds editor of Morningstar Canada. “As Barclays itself notes, the sharp shift in its fee freedom day was driven by returns, not MERs.”

So is the date entirely accurate? It depends on who you ask — and what data you use.

“Using Morningstar Canada’s Paltrak98, I recreated the calculation using February 29, 2004, data,” says Dan Hallett, president of Dan Hallett & Associates. “I excluded index funds, ETFs, pooled funds and affinity funds — all of which have below-average fees. I also excluded funds that had not been around for at least five years.

“I found a median MER of 2.68% but a net-of-MER return of 9.8% per year,” he says. “That equates to a fee freedom day of March 19 (2.68 / [9.8 + 2.68] x 366 = 79 days).”

While this represents a difference of just over three weeks from the Barclays calculation, it is still substantially later than the January 13 date the ETF firm touts as its own fee freedom day.

But part of the MER pays for professional asset management. Since ETFs are generally index funds, there is little chance they will outperform the index they mimic.

“We believe that comparing the MER of an ETF with that of the asset category as a whole is not the most relevant comparison,” says Luukko. “In our database, we differentiate between segregated funds — which invariably have higher MERs because of the insurance features that they offer — and mutual funds including ETFs.”

Luuko points out that the Barclays approach does not take into account the risk profiles of funds — “the most meaningful comparison.”

“The Canadian equity (pure) category — including the top three-year performer Elliott & Page Growth Opportunities — currently includes a number of actively managed small and mid cap funds which have little or no overlap in holdings with funds like the [Barclays] i60,” he says. “Returns have also been very different over that period — 23.6% annualized for the E&P fund versus 3.1% for the i60.”

“We also believe that a well-managed fund like the E&P fund has added value for its investors,” Luukko says. “We believe that MERs are a value for performance proposition. Some funds add value to earn their fees. Others don’t. Our reports address this issue on a case-by-case basis.”

But mutual fund fees have become a bit of a punching bag of late, with personal finance writers hailing the low-fee ETF as a way for investors to avoid paying for financial advice.

“Most Canadian mutual fund MERs include fees for advice while ETF MERs do not. Many advisors using ETFs charge 1% to 1.5% annually on many accounts,” says Hallett. “Assuming an average ETF MER of 0.25% per annum, that would bring ETFs to an ‘advice-equivalent’ fee of between 1.32% and 1.86%.”

He says using F-class mutual fund units brings the MER down to a price comparable to the net fees on ETFs, while still offering professional active management.

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“I think investors can do a lot worse than minimizing costs and getting pure asset class exposure through ETFs and low-cost index funds,” says Hallett. “I would tend to want to strike a reasonable balance between strong active managers (admittedly a subjective assessment) and reasonable costs. And there is definitely room to integrate some indexing in such an approach.”

He says he likes the idea of using index funds to gain broad exposure to the U.S. market, but that he is concerned with valuations.

Luukko points out that the MER is not the only cost investors face.

“The most relevant comparison is between the i60 and Altamira Precision Canadian Index, the latter of which also tracks the S&P/TSX 60,” he says. “The Altamira fund’s MER is higher — 0.53% — but there are no commissions to buy or sell, and there is automatic reinvestment of units or free switching into other Altamira funds.”

“I think there is some value in looking at returns versus fees but I’m not sure that [Barclays’] calculation offers much value going forward since it’s so sensitive to the trailing year’s returns,” says Hallett. “I think the basic message is sound — that investors should be cost conscious — but I think the real value of the measure ends there.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(04/07/04)