One Small Step For Investors, One Small Set Back for Investors Group

The sudden announcement that Investors Group will lower MERs (the hidden fee an investor pays every year to hold a firms mutual funds) on two thirds of their funds is a victory for retail investors (that’s you if you own IC funds). The fees are being reduced by approximately 0.4% to 0.5% per year. In short you will save approximately $450.00 every year for each $10,000.00 in IG funds you own! Given IG has approximately $60 billion in funds it manages, and using the two thirds ratio, that means Canadian investors will see annual fees drop by a collective $180 million dollars annually!

As a backgrounder, IG is extremely large in the Canadian Fund industry and has been known historically for charging MERs that were relatively high compared to their peers. In fact, IG is a primary reason why fund fees in Canada are deemed the highest in the developed world! Given the size of IG you would have expected an economy of scale advantage that would have enabled the firm to be a low cost provider in Canada. Instead, Investors Group took the approach that Canadian investors are fee tolerant and either did not care or did not react to very high fees. In short, small uninformed investors are ripe for being fleeced on fees. In fairness to IG, that seems to have been a smart bet over the past couple of decades. IG has built a huge business by being everywhere with a horde of well trained sales people. The sales pitch has been slick and having sales people coming into investors homes has built a huge base of goodwill and trust. Almost every Canadian town has a ball team, hockey team, or soccer team sponsored by the local IG office. In fact, IG has been to fund companies as Tim Horton’s has been to coffee shops.....that is if Tim’s charged $3.00 for a double double!

Investors Group has always downplayed fees and promoted the softer benefits of having a financial plan and a trusted hand to guide investors. At the same time, however, IG has kept fees high across the board. If investors try to leave IG they often find themselves having to pay thousands in penalties that the investor did not really understand. By selling large quantities of funds with Deferred Sales Charges (DSC or Back-end Loads) IG has reaped a windfall of profits even as dissatisfied investors have left. Which brings us to the crux of the matter for Investors Group: Investors have been paying the penalties, albeit not happily, and moving on to firms that charge lower fees. Consumers have become more informed, thanks in no small part to journalists such as Jonathan Chevreau (ex-National Post, Money Sense) and Rob Carrick (Globe & Mail), and fee only advice firms such as Weigh House. As well blogs, a new breed of low cost fund firms (Steadyhand, Mawer, ING, TD eFunds), and a more cynical attitude towards big financial firms has helped spread the story on fund fees in Canada.

How has this impacted Investors Group? For a long time now the IG fund family has struggled to provide quality returns. Since returns are shown net of the MER, the fund managers at IG need to overcome the impact of the large fees when comparing returns with funds who charge lower fees. This problem becomes even more challenging when fund performance is measured against low cost exchange traded funds (ETFs are the fastest growing segment of the fund market worldwide and in Canada). The result is that IG has amongst the lowest percentage of funds of all the major fund families ranked in the top categories by independent rating firm, Morningstar. Although very large, IG has only 18% of funds ranked 4 or 5 stars out of 5 on the Morningstar scale. On average fund families have 28% of funds ranked in the 4 or 5 category.

This has resulted in retail investors shunning the mediocre performers. IG has had net outflows of funds for the last three quarters. In Q1 2012, year over year inflows dropped by 65%. When these types of numbers are appearing it likely follows that the sales team at IG is starting to defect. With sales driven by relationships, a salesperson often takes a large number of clients with them when they defect. In the fund industry competitors will often make it attractive for sales teams to switch firms. Being able to show existing clients that a new firm has better ratings and lower fees is a big sales assist for disgruntled sales people.

So, in the end IG is making the changes necessary to ensure they can continue to retain sales teams. They are not making changes in order to benefit investors nor are they reducing the fees on all their funds. What is happening is that IG is being forced to acknowledge that the days of fat profit margins and poor performance are threatened. IG is a smart company and they will spin their decision to seem more consumer focused than it is. The way to force changes is to threaten profits and thousands of small investors have done just that! It is the first small step in a long journey but it is a welcome site for all investor advocates.

In the end IG will act in an economically sensible way, as they always have. The company still has a large profitable business and a large well trained sales team. They will make revenue adjustments when forced to and not a moment before. That is no different than a bank lowering a credit card rate or a car company dropping prices. The main difference is that MERs are hidden from monthly statements and thus consumer awareness is slower to develop. While many advocates hold IG in contempt for gouging consumers for decades, the truth is always somewhere in the middle. IG exploited a business opportunity which is now being slowly eroded. As retail investors continue to become more enlightened IG will find new areas to exploit. This is more evolution than revolution but it is a great start on the road to a fair and level investment market for Canadians.

In the meantime, congratulations to the thousands of investors who voted with their wallets and forced a major change in the behaviour of the fund industry! Keep up the great work!

mike

Leafs, Mutual Funds, and Other Addictions

As I watched in awestruck horror, my Maple Leaf hockey team slowly disintegrated before my eyes this winter. It is a very difficult time to be a Leaf fan and it is getting harder to say ‘we will get’em next year”.  Of course my friends all claim to be long time fans of Boston or Chicago or anybody else that has had recent success. Many who claim to be friends seem to take great joy in pointing to the folly of being a fan of such an incredibly bumbling organization. The senior leaders in the Leaf hierarchy continue to insist they care more about winning than making enormous profits; yet year after year they manage to seem cheerful when they tell shareholders about the huge profits they have ‘earned’ (?) for the owners. As I watch this unfold I struggled to find an analogy for being a loyal Leafs fan.

Then, I had an epiphany!  I opened my investment statement and it all became clear. Cheering for the Leafs is the very same as investing in Mutual Funds! How could I not see it before? Think about the following points and see if you agree:

1.       They both seemed like a good idea years ago when I invested in them. In the early years (I am mid-fifties in age) the Leafs were winners and life was good for Leaf fans. In the early years Mutual Funds paid double digit returns and investors all made money!

2.       Being a fan of the Leafs is an emotional journey. They raise you up just to knock you down again and then they repeat the pattern endlessly. My Mutual Funds have also had great days, weeks, months and even years but they are now worth no more (and often less) than they were worth when I originally invested in them. The crashes are sudden, without warning, and devastating. Sound familiar?

3.       The Maple Leafs cannot seem to recognize quality assets. They trade draft picks and young ‘stars- to- be’ for old tired and worn out players. When they do get a good spot in the draft they still manage to find a dud. Not surprising all the top free agents stay away. Funny, when I look back at my fund holdings I see the same story. Stocks bought when they were past their prime and stocks sold just before they went on a tear. Top fund managers leaving for better firms and no quality replacements in sight.

4.       Leaf tickets are priced as if the Leafs of old were still here winning championships. Why am I forced to pay huge ticket prices to see a team that stinks! Similarly, Mutual Fund fees are the highest in the world here in Canada and performance also stinks. Paying a couple or 3 per cent on returns of 12-15% was not bad in the eighties. But paying over 2% now for funds that return nothing over a decade seems a bit much. I am being ripped off every way I turn!

5.       Sports analysts (talking heads) continually pump up the volume on how great the Leafs will be soon..... not now, but soon! Come the trade deadlines or draft day you would think the Leafs had phenomenal assets to trade or the next great star about to be drafted. Soon we realize it was all B.S. designed to get us to buy more tickets and Leaf jerseys with a new saviors name on the back. As for Mutual Funds, every terrible statement comes with an explanation of why now is the time to invest. Markets are just about to go on a bull run and the newest stock picker hired by the fund company is a real genius! Remember this RRSP season you need to double up on your deposits because this coming year is the big one for investors.....right?

6.       Perhaps the biggest similarity is my inability to wean myself off of these addictions. Why would I continue to work with an advisor that I have come to realize is just a salesperson sucking me dry? Why as a Leafs fan do I still turn on the game and start every season thinking this year will be different? Alas to this simple question there is no simple answer!

Having carried the analogy far enough I now see there is one huge difference. I do not really love my advisor/salesperson. I can picture life without them. I can manage my own investments or I can find a low cost fund firm like SteadyHand or Mawer or Leith Wheeler or I can buy low cost ETFs. In short, I have control over whether I use an advisor/salesperson.

As for the Leafs, well matters of the heart are more difficult. I will continue to try to grow apart from the Leafs but I can never, ever, ever, ever cheer for Montreal or Ottawa! That would just be too much to ask of a recovering Leafs addict!

SoisMike

Investor Traps: Covered Call ETFs

One significant challenge for investors is to ignore information that they discover while researching investment options. A classic example of this is information which seems straight forward but may not be suitable for the portfolio strategy an investor is trying to implement. Part of the challenge is that the marketing arm of the product manufacturers (mutual fund or EFT companies specifically) do a great job of hyping the benefits and an even greater job of downplaying or ignoring the risks of the product. Often new investment products are created for a specific requirement, such as enhancing income or hedging a long position and then they become popular as the “new hot product”!

Let’s look at the example of Jane Smith, an investor in her 60’s approaching retirement shortly and managing her portfolio with a conventional diversified ETF portfolio. Her holdings include ETF’s tracking the TSX60, the S&P 500, EAFE Index (Europe, Australia & Far East) and the Dex Bond Universe. Jane has a strategic asset allocation that is 75% fixed income and 25% equity exposure. This strategy is designed to protect her substantial RRSP holdings from market volatility while holding sufficient equity exposure to protect against any uptick in inflation through equity growth. Jane is looking for returns of inflation plus 2%.

In researching her investment options Jane comes across a new ETF that has been gaining in popularity; a fund that writes covered calls on bank shares. In checking out the ETF Jane sees that the current yield is over 6% at a time when her fixed income portfolio is yielding 3.68% in comparison. Given her concerns about the low interest rates on her large fixed income portfolio Jane contemplates reducing her fixed income ETF holdings by 10% of the portfolio and adding 10% to a “covered call elf” holding.

What Could Go Wrong?

In further reviewing the covered call strategy Jane starts to feel a little less excited about her new strategy. While current yield is great, Jane begins to understand that the greater yield comes with certain risks that are not always readily apparent. That prompts Jane to run through a few scenarios to see how her “new” strategy would react to certain market changes that might occur.

1-      What if interest rates remain low or even go lower? The covered call strategy is based upon implied volatility in stock prices so it does not directly react to interest rate changes. As such it does not directly assist the portfolio to have low interest rates; however if the ETF continues to provide a 6% yield it should have a positive impact on Jane’s portfolio.....right? In fact, since current yield is defined as recent period income divided by portfolio value, a $6 income on a $100 portfolio provides a 6% current yield. If the portfolio drops in value to $75, the current yield becomes 8%. In looking at the 1 year performance of the new fund (just over 1 year old now) Jane discovers the rate of return has been -1.5% from March 2011 to March 2012. That seems perplexing given the fund is yielding such a high amount? Maybe current yield is not the best way to look at this ETF!

2-      What if rates rise sharply? If rates rise the value of Jane’s existing fixed income will likely drop. Fixed income values generally move opposite of interest rates. Obviously the higher rate scenario favours holding covered calls versus fixed income..... right. Well, maybe! If rates rise what will the bank stocks held by the ETF do? Will investors sell stock and buy fixed income when rates rise? If so what will happen to the value of the underlying bank stock? In fact, banks tend to benefit from higher interest rates (think of interest rate spreads as banks raise mortgage rates and credit card rates). While no outcome is guaranteed, Jane is comfortable that if rates rise this strategy should be either slightly positive or neutral in her portfolio.

3-      What if stocks go on a big bull run? If bank stocks benefit from positive stock markets there could well be a doubling or tripling of some bank stocks. After all, TD Bank common stock went from the high $20’s to the low $70’s after the 2008 crash ended! Holding the long positions on bank stock in the ETF might bring a real growth spurt to the portfolio. Right? Well, actually no. While the ETF holds a lot of bank stock, the gain from an increase in the underlying stock values would benefit the investors that bought the covered call options. If a stock was valued at $60 and a covered call was sold at $62.00, the ETF would make a profit of $2.00 plus the option premium of perhaps $1.00. If the bank stock went to $80/share the ETF would still only see a maximum of $3.00 from the $20.00 increase! Suddenly giving up a $20/share gain for $3 does not seem as positive.

4-      What if the stock market plunges downward?  The covered call strategy is a “defensive strategy” (according to the marketing material anyway) so it must protect my portfolio from large losses.....right? It would seem to make sense that the offset to sacrificing large gains when markets rise (scenario 3 above) would be that my portfolio would be sheltered from large losses in return..... right?  Well, actually, no! That is not the case with covered calls. If the bank stocks dropped from $60/share to $40/share the fund would need to hold the shares for the length of time that the call option remains in place to insure the option remains a “covered call” and not a “naked call”. The fund holds the stock regardless of the market performance and the only income to offset the loss is the small call premium (our $1 theoretical premium as above). The net result is that the fund looses $19/share instead of the $20/share the market drop infers. 

Given the above analysis, Jane pulls out her original Investment Policy Statement and reviews her strategy. The equity holdings are designed to provide growth which protects the portfolio from being eroded by inflation. That is accomplished by using gains from a rising stock market to cushion any losses in fixed income values caused by inflation. Since the covered call strategy limits market gains the covered call strategy works against Jane’s overall strategy.

Jane's original strategy called for limited equity exposure to ensure stock market losses do not diminish Jane’s nest egg. The covered call strategy leaves the portfolio exposed to any significant market drops so that also works against Jane’s original strategy. 

Decision: In looking at all options Jane realizes that the covered call option is a higher risk strategy than holding fixed income and it has the potential to 1) dampen equity growth, 2) expose the portfolio to large equity losses, and 3) in a low volatility stock market with concurrent low interest rates, it could increase current yield slightly. In short the covered call strategy can help a little or hurt a lot, but it cannot significantly improve her portfolio. Jane reviews her portfolio performance against her goal of making returns of “inflation plus 2%” and finds she is currently still meeting her target rate of return. As such she decides not to utilize the covered call ETF that all her friends are excited about. What she will do is file away the information. Every product serves a purpose but not every purpose serves a portfolio strategy. In this case doing what is popular with investors today and what appears to offer some immediate benefit, would actually weaken the investment strategy and change the risk profile on Jane's portfolio. Sacrificing equity gains while taking full equity market risk is a poor trade off. As well, not making the addition to the portfolio keeps the MER lower, reduces trading costs to rebalance the portfolio, and makes the portfolio simpler to monitor. Jane knows that an investment portfolio is like a bar of soap....the more you handle it the smaller it tends to get! 

Note: Covered calls on bank equities were the most popular strategic ETFs in the first quarter of 2012. The largest volume growth was a bank shares focused covered call ETF that provided returns of just over 7%. Holding direct common shares in TD bank provided over 10% capital gains as well as additional dividend income. The covered call strategy provided an enhancement in returns versus fixed income however it provides the risk profile of equity. When properly compared to narrow focused bank equity returns the results were less than stellar. The message is not that covered calls are a bad strategy for everybody. The important message is that any security you purchase needs to support your overall investment strategy, your portfolio risk profile, and your investment return requirement. Covered call strategies are marketed as a lower risk strategy and generally compared to fixed income investments. In fact they are equity and should be considered a higher risk strategy with a potential downside far greater than any typical fixed income strategy. Risking a 20% or 30% downside or missing a 20% or 30% gain are high prices to pay for the extra yield you may see in the short term.

sois mike

SROs Fiddle While Investors Get Burned

IIROC has recently released new information on the implementation of its chosen Customer Relationship Model (CRM). Before I add any comments let us take a look at how IIROC describes itself and the quality of their efforts.

“IIROC is the national self-regulatory organization which oversees all investment dealers and trading activity on debt and equity marketplaces in Canada. IIROC sets high quality regulatory and investment industry standards, protects investors and strengthens market integrity while maintaining efficient and competitive capital markets.”

This gem is found in the March 26^th news release issued by IIROC.  Perhaps a less egocentric organization might have stated that it has “a mandate to set high quality regulatory and investment industry standards.....”, however IIROC appears to have declared victory.

Sadly, IIROC acts just like most self regulatory organizations (SRO). They react late, water down the regulations to reflect the desires of the dealers, and generally only act when the pressure to do something becomes embarrassing. And do not kid yourselves, these folks do not embarrass easily.

The move to clarify fees in the CRM is far too late and the ability of salespeople to call themselves advisors regardless of any qualification standards seems to go unnoticed. As to having salespeople provide better information on risk, well that is almost impossible since no credible standard exists on how to rank a mutual fund’s risk profile. In effect, the standard is that each fund can set its own risk ranking so long as they feel it is appropriate. Wow, feel safe?

The mandate to set high quality standards was never intended to read as “minimum standard that is acceptable to all stakeholders”. In fact the idea of utilizing an SRO seems to be something that is never questioned in Canada. Whether it is the Canadian Medical Association never seeming to sanction doctors until the media gets involved or the regulatory bodies that rarely expel a Certified Financial Analyst in spite of the numerous investor complaints; it seems that in Canada the major role of an SRO is to lie low, deflect criticism, and act only when forced to. It is safe to say no bold initiative ever originates with an SRO.

“So what”, you say? The net result is that Canada continues to fall further behind other nations when it comes to protecting investors. Specifically, I mean small retail investors. So what would make me happy you ask? How about some big thoughts! Some regulations that would actually drive real change and turn the industry in a different direction. Here are three ideas that would change the landscape for investors in Canada:

1-      The first is a very simple move to protect investors and is at least partially in place in a number of countries. Ban deferred sales charges (DSC, Back End Load) and trailer fees. Investors can either pay the salesperson an up-front fee or pay an on-going fee to the salesperson directly. hidden third party fees are never a good solution for investors.

2-      Require all mutual fund salespeople to become licensed to sell ETF securities. No salesperson selling mutual funds should be able to do so without providing a comparison to the top selling ETF fund in terms of performance and fees, as well as the cheapest priced mutual fund in the same category. This is a low threshold but one that is not even being talked about. Consumers do not know their options and this would force salespeople to at least acknowledge that lower cost options are available.

3-      Any person selling securities should have a fiduciary obligation to put the client’s interest before their own. Most investors already think this is the case and are shocked to find their interests are not primary and often not even secondary in the process. Salespeople currently can first look to what pays the most commission, then look to see what most benefits their parent company, and then select any fund that meets those requirements and is deemed “suitable” for the client and sell it to an unsuspecting investor.

Do I think any of these changes will happen? Actually, yes I do. They will happen when every other major country has already made similar changes. It will be very late and not likely in my lifetime. Look to Australia where governments are not afraid to challenge the financial status quo; look to the U.S. where litigation helps shape regulations; and look to Britain where government has created regulatory bodies with a true focus on protecting investors.

In Canada we can dream big......but we do not have the courage to take on the establishment....yet!

Mike

INVESTING IN BAD TIMES!

The current investment climate is about as bad as it gets when you look back over an extended time period. Canadian investors have watched as equities vary between days of terror (huge market drops) and days of despair (slow death via multiple days of small declines). The odd good day or week in the markets seems to just tease us for what might have been had we invested in the 90’s instead of this century! Even the old standby, the Money Market Fund, has proven to be neither safe nor profitable. We lamented the lost decade for equities from 2000 to 2010, and then started the new decade with negative equity markets for 2011.

So what can we do and what should we do!

1-      We CAN stop adding to the problems by making poor decisions about our investment strategy. The typical investor in a MF or ETF Index fund will make significantly less than the fund itself over the course of a typical year. That is because investors jump in and out of the equities market based upon the current emotions they are feeling. Studies show that this undisciplined approach will cost investors up to 4% less return than a mutual fund would make on average. Professionals do NOT jump in and out of the markets based upon emotions. They follow an Investment policy Statement (IPS) that outlines the minimum and maximum percentages of equity that MUST be held in the portfolio. For those that wondered about the definition of “rebalancing” a portfolio; that is the term used for bringing a portfolio in line with its IPS guidelines. Without an IPS you CANNOT rebalance your portfolio!

2-      We CAN stop pretending that the folks who make a good living managing investments have an ability to predict what stocks will go up or down next week or next year. Professionals can help you select stocks which have good balance sheets and good management in place. They can also help you ensure your portfolio is well diversified. Other than that, professional stock traders are of little use unless they can provide insider information (which in general is illegal). In 2011 the consensus forecast of investment managers in Canada was for stocks to outperform bonds and commodities. It will come as no shock that a) they were wrong, and b) they have made the same forecast for 2012. In fairness.....they eventually will be correct just based on the law of averages!

3-      We CAN reduce the fees we pay. With investor returns at historic lows we cannot continue to give a guaranteed 2-2.5% return to investment salespeople. If markets were to provide you with the 4%-5% returns we expect in the near future, a fee of 2.25% would be 45-55% of your total investment return. In years where markets drop, like 2011, the fee just increases your losses. If you negotiated a fee of 1.25% you would be giving up only 25% of the same return forecast! If you used ETF Index funds you could reduce the fee drain to a fee of .25% and have only a 6% fee drain.

While markets are certainly tough it does not mean we cannot do better. A little effort, some simple strategies and a calm demeanour can go a long way to lessening the pain of being an investor today!

If you need an IPS then ask an independent (non-selling) firm to customize one for you!

Soismike

Well, it was another year of frustration for “real investors”. By “real investor” I mean those of us who trade without access to inside information and who cannot augment our returns through hidden fees or commissions. While we will lick our wounds and carry on, we should also track where the smart “professionals” were focused in 2011 to see where we missed the boat.

Consensus Forecasting for 2011: The “professionals” forecast the market performances every year and then a “consensus report” is tabulated to allow us to peak under the curtain and see what active traders are doing to beat the markets. The asset class forecasts were very clear that security performance in 2011 would see returns ranked as follows:

-          Equity stocks would be the best performing asset class

-          Commodities would be the second best performing class of assets, and

-          Bonds would trail the above classes and provide weak performance

Based upon the forecast, you would overweight equities, diversify with commodities, and minimize your bond holdings.Let’s see how well the smart money did in forecasting 2011.

-          Equity returns in Canada ( TSX broad market total return index) -8.71% and if you choose to look just at the blue chip TSX 60 returns were -9.08%

-          Commodities as measured by the Auspice Broad Commodity Index was 1.78% to the positive side

-          Bonds as measured by the Dex Bond Universe was up 9.7%

Wow, the smartest guys on the street managed to show an amazing dyslexia of returns! They used thousands of analysts to crank out the research math and got everything backwards! In fairness however, the forecasts were great for revenues at the brokerage firms as investors traded heavily into the markets based upon the forecasts. By the end of the investment rich RRSP seasons investors had bid up the equity markets and the research looked great. However, once all the suckers....um, investors were fully invested, the professionals did a quick sprint to the exits, leaving the retail investors holding a smelly mess of equities. The TSX dropped from the lofty mid 12,000’s to the more realistic low 11,000’s. Unfortunately, those who followed the advice in late February and early March can only wish they had lost 8 or 9%! In fact many will see 15-20% drops with their RRSP investment money.

So, how did a conservative indexer do in this type of market? If the pro’s got it wrong we can only assume the indexers got creamed! Our conservative 50/50 balanced model would have received the returns of a typical mix of ETFs somewhat like the following: 

ASSET CLASS	WEIGHTING	ETF SYMBOL	RETURN
Cdn Equity	25%	XIU	-9.22
US Equity	12.5%	XSP	1.07
EAFE	12.5%	XIN	-12.7
Bond	50%	XBB	9.38
Total	100%		0.92%

Well, it was definitely a tough year; however staying diversified reduced the damage significantly. Even if investors reduced the risk by splitting the fixed income between short and long duration bonds (50% XBB and 50% XSB), the overall return would be -0.3% for the year 2011.

Obviously the higher the Canadian equity component or the EAFE equity component, the worse the overall portfolio performance. For those active traders that jumped on the gold bandwagon the entry point was a challenge. On the whole XGD (the gold ETF) was down 14% and the much recommended emerging markets saw a decline of 16.4% as measured by the emerging market index. So, if you followed the professionals you were heavy equities, heavy emerging markets, heavy gold and light weight bonds. If you followed your Investment Policy Strategy as a conservative investor you retained your capital! Thank goodness I am a dull investor with a conservative IPS!

soismike

Part Two: Why Mutaul Funds are like Popcorn.....Explaining The Fee Gap

Mutual Fund Fees: Part Two     

In part one we discussed the position put forward by Fund Companies and Advisor/salespeople that the Management Expense Ratios in Canada represent fair value for investors. The logic they use does not hold water when you break down the component parts of the MER between investment management, sales channel expense, and the “advise” component.  As we showed in the previous blog, the portion that is reasonably assigned to “advice” seems to be far too high. In an efficient world we have shown that a typical Canadian Mutual Fund with an MER of 2.4% per year would have approximately 1.2% available to cover the advice cost. In fact, the fund companies generally pay a “trailer fee” to sales people to cover the cost of the annual advice component of the fee. That trailer can vary between 0.5% and 1% per year. This would suggest an average advice fee of .75%. This suggests that there is another fee component that we are not accounting for?

Formula: MER = investment management expense + sales channel expense + advice fee + ?

                2.4%= .7% + .5% + .75% +?

                ? = 2.4% -.7% -.5% - .75% = 0.45%

Where does the mysterious 0.45% go? In fact, on the typical mutual fund with a 0.5% trailer the mysterious “?” factor is 0.95%. In effect, we can surmise that Canadians are paying an extra half to one per cent on mutual funds after all reasonable fees have been accounted for. Who gets the extra fee?

Alternative Scenario: Mutual Funds in Canada are priced to reflect what an uninformed investor can be convinced to pay. The mutual fund industry and the “advisor” industry have set up an ideal world for the exploitation of investors. The key components are as follows:

Ø  A closed market where prices can be set by a few large companies.

Ø  Self regulatory oversight where the same companies can dominate the rule making process

Ø  A sales channel that can act to keep the investor unaware of low cost alternatives

Ø  An uninformed Government that can be manipulated to support the ongoing deception

For those that think this is about a big “conspiracy theory”, let me assure you it is not. Conspiracies are too complex and the details would eventually leak out. Instead this is about a combination of ignorance, laziness, and business strategy.

Ignorance & Laziness:  Most of us slowly and almost unwittingly enter the world of investing. Our first investment need is often an RRSP or TFSA account. Investors are typically directed to their bank or “advisor” to teach them how to manage their investments.  Often young adults will learn important skills from their parents; however the financial world has changed so fast that we do not have a pool of knowledgeable parents to educate the young investors. The educational system does not teach money management and, in truth, most investors are unaware of the problems and thus of the need to become educated. Investors are focused on their jobs, family, and day to day life. The path of least resistance is to be a part of the current system and use the bank or fund company sales channel. This is a combination of laziness ( not getting ourselves educated about investing) and ignorance (not knowing the current process is a problem).

Governments are also a part of the ignorance problem. Rather than regulating the investment process the governments have chosen to allow the industries to regulate their selves. These “SRO’s” include the Investment Funds Institute of Canada (IFIC) and the Investment Dealers Association “IDA” whom have morphed the regulatory duties into the Investment Regulatory Organization of Canada (IIROC). In short, those who profit the most from unfair fees are the group the government allows to set their own rules and standards. The result of this has been a government who does not protect investors and who then actually looks to the industry SRO to provide guidance to the government on industry policy. An example of this collusion was the decision by the government of Ontario to exempt fund companies from disclosing the HST paid on mutual funds. The only possible purpose in doing so was to hide any information that could allow investors to determine their monthly fund fees. The government bought into the bizarre suggestion to exclude the information from statements and the industry benefits at the expense of the investor.


Currently we are seeing an even more egregious example of an industry run amok as the various levels of governments defer “investor education” programs to committees dominated by executives of financial firms who sell funds. Most people who understand the industry are left to shake their heads and mutter about the “wolf guarding the henhouse”. As for the government, they appear to be happy to defer to the industry in a way very similar to how the average investor defers to the mutual fund sales status quo. Governments are not being so much duplicitous as they are being ignorant and lazy. Why look for problems and solutions if investors are not making waves.

Business Strategy: The fund executives are in the business to make profits for investment firms who employ them. Period! They are not in the business of providing advice, education, or regulatory oversight. Their business strategy, however, necessitates that they control the advice, education and regulatory processes that impact the fund industry. Their strategy has been to control the process from start to finish and create a closed loop.  The industry controls the production of funds, the regulatory oversight, the distribution of funds, investor education, provides guidance on government policy decisions and sets the pricing of all services to the investor. It is a great business model and one that generates massive surplus profits for the fund industry.

On the Street Impact: The impact of the strategy is felt directly by the investor. While most investors are not aware of the strategy they are very aware of the impact it has had on investors.

-          Canadians pay the highest fund fees in the world

-          Canadians deal with “advisors” who are in fact licensed sales people and have no legal duty to put the client’s interests before their own. In actual practice advisor/salespeople clearly prioritize their own benefits ahead of their clients. For proof look only as far as the next point.

-          Over 80% of mutual fund sales people are NOT LICENSED to sell competing products such as low cost index funds that trade on the TSX. These funds are amongst the top performing funds every year and cost as little as a tenth of the cost of equivalent mutual funds.

-          Canadians buy a significant portion of their mutual funds with deferred sales charges. These charges are being banned in a number of countries (Britain, Australia) and are rarely sold in the U.S. where investors are much quicker to sue an advisor over improper advice. These fees are designed to lock an investor into a single mutual fund company for up to seven years with little or no corresponding benefit to the investor.

-          Canadians have no binding complaint process that allows for arbitration of investor complaints with multi-billion dollar financial firms. If a firm does not pay up the individual investor faces the daunting task of suing a firm that has the top securities lawyers on speed dial.

-          Canadian mutual fund statements and disclosures are amongst the worst in the world. Investors are not provided with monthly cost of fund fees, personal rates of investment return, nor proper benchmarking information.

-          Risk ranking of various mutual funds has been left to each individual fund company. In fact, the same fund can be rated at a different risk level by two different distributors at the same time. The acceptable risk rankings have no basis in quantitative analysis and thus are at best useless and at worst dangerous.

The above are only a few of the negative impacts we can attribute to the business strategy of Canada’s large fund firms. However, as any fund executive will tell you....it’s not personal, it’s just business!

As Canadians struggle to build their retirement nest eggs it should be clear that at least part of the problem for investors is the significant skimming of retirement funds by mutual fund companies and so-called advisers. In the real world the cost of the additional and excessive fund fee is reflected in delayed retirements, eroding retirement portfolios, improper retirement planning advice, and a general sense that the average Canadian cannot seem to get ahead.

Perhaps this is part of the issues that pushed some people to Occupy Wall Street! Add in the bank strategies on increasing consumer debt, excessive credit card fees, excessive chequing account fees and you begin to see a pattern of skimming that leaves the 99% with little to cover basic living expenses. Of course ignorance and laziness are somewhat self induced so we can solve these issues ourselves. However the solution will have to start at the ballot box because currently the fund firms hold all the trump cards!

Wow, that sounded more political than I intended! This blog does not take political stands but fortunately (or unfortunately in this case) all political parties currently bow to the financial firms with equal deference.

Sois mike

Quick Hit on Index Linked GICs

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I know I said my next blog would be on fund fees however I wanted to acknowledge a great article by John Heinzl in the Globe today. It fits into the investor education debate that is ongoing.

Why the Blue Chip GIC isn’t a blue chip investment


Investor Education: I noted a great article in the G&M today by John Heinzl. For those that do not follow John, he is one of the best writers when it comes to both understanding and explaining investment products and strategies. His topic was a follow-up on one he wrote when BMO introduced its unfortunate “Blue Chip GIC” product. John felt it was a product designed to heavily favour bank profits and was highly unlikely to be a great product for the clients of BMO who were sold this product. Note John made this call a year ago!

John had explained the basics of the product and how the structure was likely to work against clients expecting a reasonable return from a product offering “guarantee of principle” but little in the way of upside returns. Not surprisingly, the GIC paid investors a paltry 0.2% for a one year term. We thank John for the follow up article as it clearly shows not just that the product was a poor performer; but more importantly it shows how predictable the poor results were. John “forecast” the performance as opposed to merely stating it after the fact. Thanks John!

For investor advocates, John’s original comments were no surprise and the performance of the GIC was equally predictable. BMO is not alone in this cynical exploiting of investors through “index linked GICs”. TD bank also pushes staff to maximize the sales of these products and rewards those who do so. So does most every other bank in Canada. The marketing pitch is to play on the fear that markets are unpredictable and that investors should try to keep their money safe. Given the losses generated by mutual funds over the past few years, one would expect that many investors are ripe for this sales pitch. The reason the pitch works is based upon a few key investor attributes:

1-      Most investors trust bank employees and do not realize that most bank employees do not understand how the actual investments work.

2-      Investors are not educated or trained to understand the full impact of the underlying terms and conditions on these complex products. What the investor hears is “GIC” and “guaranteed”. The belief is that any market gains will increase returns and any losses will be absorbed by the bank. Unfortunately that is not the case! The underlying terms were designed to minimize payouts such that even a positive average return on the underlying stocks would not necessarily generate a bonus. In effect, the game was tilted in favour of the bank.

3-      In general, the more complex the product, the larger the profit margin is for the bank. This suggests that the bank benefits from having both the staff and the client uninformed.

With the banks all pretending to support investor education, this is a practical example of why you cannot believe the basic information provided by your trusted local banker. The issue is that the employee does as they are told/trained in the belief their employer would not treat customers unfairly.

The customer in turn trusts that the local bank employee would never do anything that would treat a loyal customer unfairly. In fact, a highly paid bank executive signed off on the product because it generates much higher bank profit than a conventional GIC....period! Client investment returns or “fairness” never enters the picture for the executive. So long as it is possible to market a scenario where the client might have done better with the “linked GIC” the bankers can sleep at night without acknowledging how unlikely a positive outcome is for most clients. If a client complains the banker will simply suggest the GIC was better than if the client had actually bought the stocks and lost much of their investment capital. Of course the problem with that answer is that the client never intended to buy the underlying stock! They went to the bank to buy a simple GIC and were sold this crap instead!

Beware bankers bearing gifts!

Mike

Why Mutual Funds are like Popcorn

 Why Mutual Funds are like Popcorn!

The Canadian mutual fund industry runs on the theory that Canadian investors will voluntarily pay annual fees to mutual fund salespeople in return for selling a mutual fund and providing advice. The main players in this business are a) the investor, b) the mutual fund company, and c) the salesperson.

The key to implementing this strategy has been to ensure that the investor is not provided with either a minimum service standard for the “advice” component nor a summary of the fees being paid for the “advice” service.

If we focus on the retail investor; the investor is paying an annual MER which covers everybody’s expenses and profits. In fact, the investor is the only source of money and the only person who is not guaranteed a profit every year. As such, we can conclude the embedded cost of the “advice” is equal to the fee paid by the investor less all expenses involved in fund manufacturing and sales.

Formula: Investor Cost is defined as: MER= manufacturing cost + sales cost + advice costs

The Advice: When fund companies talk about “advice” being provided they do not attempt to  explain why the advice would need to be facilitated through the fund company’s salesman. Since fund companies are not promoted as being in the business of providing advice, it would seem that the advice component would be a distraction from the core business of managing money. Fund companies do have expertise in managing investments and that is where they are most efficient. In many cases the fund company will outsource the “advice” component to an independent salesperson. These salespeople generally call themselves “financial planners” or “advisors”, although these titles mean nothing specific in terms of knowledge. The “advice” component is non-defined in terms of either quality or frequency of the advice investors should receive. As such the salesperson does not need to meet any standard for advice nor confirm any advice has been provided in order to collect the advice fee. In fact, the commission for providing the advice is often paid to the salesperson up front before any follow up advice service would be expected to take place.

COGS: Fund companies are in the manufacturing business. As such the fund companies are fully aware of the accounting term “COGS” or cost of goods sold. The COGS for a fund company is likely in the order of 0.4-0.5% based upon the wholesale pricing that is available. Some would argue the number is more likely between 0.2-0.4% but let’s assume the higher number to be conservative. Adding a margin for strong profits, the manufacturing company can thrive on a price of 0.7%. This is on the high side of the estimated cost range and provides a profit margin of 75%-100%.

 Having solved for what appears to be a generous but reasonable manufacturing cost, the formula can be updated as below:

Investor Costs (MER) = manufacturing cost + sales cost + advice cost

                                    = 0.7% + sales costs +advice costs

Sales: Mutual fund manufacturers also need to sell their product. The cost of the sales process varies based upon the sales channel(s) the company uses to distribute their funds. Some companies such as Steadyhand sell manufactured products directly to investors. As such, a large investor can achieve MERs as low as 0.77% for a Canadian equity fund and just below 1% on foreign equity funds. Steadyhand is not a manufacturer, but is a low cost distributor of custom funds they create through investment management firms who provide wholesale services to Steadyhand. Steadyhand does not utilize an “advisor” sales force, but handles sales via phone and internet which is lower cost and quite efficient.

Alternatively, bank mutual funds are sold by a “captive” sales channel. The bank’s employees are most often salaried and the salary cost is spread across multiple product lines. This sales channel is low cost and efficient as the banks’ leverage internet sales, discount brokerage sales and branch staff sales. TD bank offers a balanced mutual fund through its e-series for 1.28%. The e-series does not provide an advice component so the fee is comparable to Steadyhand. The Steadyhand pricing reflects a small focused sales channel approach, while TD represents a large multi-channel sales approach, neither of which is advice focused.

The combined manufacturing and sales channel costs for Steadyhand  are assumed to be mid way between the lowest Canadian and foreign equity MERs. Subtracting the 0.7% manufacturing cost leaves a sales channel cost of 0.14% ( 0.84 - 0.7 = 0.14%).  TD sales costs using the balanced fund as the average would be 0.58% (1.28-0.7= 0.58%). Let’s assume the sales channel expense of a fund company is on the higher end of the range provided by the two examples, and we can set sales channel expenses at 0.5%. Our formula now looks like this:

Investor Costs         = 0.7 + 0.5 + advice costs.

Given the average MER for Canadian equity funds is approximately 2.4%, the formula can be solved as follows:

Investor costs= manufacturing cost + sales cost + advice cost

2.4% = 0.7% + 0.5% +advice cost

Advice cost= 2.4% - 0.7% -0.5% = 1.2%

The advice component is thus valued at 1.2%. That is half the cost of a typical equity fund MER in Canada. In effect, if this is correct, fund companies are in the primary business of selling advice since it accounts for the largest component of their MER fee.

U.S. Comparison: If we were to use an example of typical U.S. mutual fund fees the formula appears to work reasonably well. Based upon an average MER of 1.4% for US equity mutual funds the formula looks like this:

Investor costs= manufacturing cost + sales cost + advice cost

1.4% = 0.7% + 0.5 % + 0.2%

The advice cost is 0.2% and the fund companies are definitely in the primary business of manufacturing and selling investment funds. If we assume U.S. funds have a lower cost environment and economies of scale, the advice component may be as high as 0.3%-0.4%, but it is still the smaller component of the various fees in our formula. Regarding economies of scale, the Canadian fund firms manage hundreds of billions of dollars in mutual funds yet the largest firms such as Investors Group have amongst the highest fees. This suggests economies of scale are not passed down the line by fund companies in Canada.

Popcorn Theory: A similar approach can be used to look at the movie theatre business. This comparison would provide a glimpse of what may be wrong with the conclusion that fund companies are really charging fees for “advice” as opposed to investment skills.

When my wife and I head to the theatre it is for the express purpose of seeing a movie. We understand the evening will cost a set amount of money and we are prepared to spend accordingly. We do not divide the cost of the event into “movie cost” and “snack costs”. We understand we will have popcorn, a soft drink and we will watch the movie and it will cost around $30.00 for the evening.

The theatre owner, however, does care how we spend our money. Movie theatres make extremely large profits from selling popcorn. Expenses in preparing popcorn are very low, popcorn profit margins are very high, and little skill is needed to train staff. The actual movies by contrast are expensive to make and thus  expensive for a theatre to purchase. Movies can be big winners or they can be expensive duds for the theatre owner. On the surface, it would appear the theatre owner would be better off if they focused on selling popcorn and not on the low margin movie component of the business. However, here is the catch: in real life nobody would travel to a theatre just to buy popcorn. The movie is the sizzle that creates the opportunity to sell the popcorn! Without the movie there is no opportunity to distribute the extremely profitable popcorn!

 Applying the popcorn theory to the investment business; few investors would buy mutual funds without the confidence they were getting valuable investment and planning advice. In essence, investors do not seek mutual funds, they seek advice!

 The fund companies know that the "advice" component attracts investors who otherwise would not purchase mutual funds. The "advice" performs the same function as the "movie" does.... it attracts clients who can then be sold a very profitable secondary product. In the case of investors, the very profitable secondary product is the mutual fund.
 Further proof that this comparison is correct is found in the high volume of expensive mutual funds sold with an advice commission, versus the much smaller sales volume of lower cost, direct sale mutual funds. Investors overpay for the mutual fund to get the perceived advice they are seeking.  The main difference is moviegoers know what the popcorn costs them while investors face a hidden "advice fee" buried in the MER costs.

In the next blog we will delve a little deeper into why the Canadian mutual fund fee model does not make sense and how that contributes to Canada's exorbitant mutual fund fees.

mike