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Rising MERs
Are mutual fund fees on the rise?

This week, fund researcher Morningstar Canada released the results of a study aimed at quantifying the trend in mutual fund management expense ratios (MERs) over the past eight years. The trend they found was a rising one. Not surprisingly, the study has attracted industry criticism, but I think everybody's making too much of this study.

The numbers

Morningstar quantitative analyst, Mark Warywoda, authored this study entitled "Why Canadians pay for fund management". The industry is up in arms because of the overall conclusion that average fund MER has increased from 2.02 percent in 1995 to 2.62 percent today. What many have missed is what the report clearly states that: a) those figures include the much more costly segregated funds, and b) the average figures are calculated using a "simple average".

To address these biases, Warywoda excluded seg funds and weighted the MERs of the various funds according to how much money is held in each (i.e. so that a fund with lots of investor money will be more heavily weighted than a brand new fund with no assets).

What he found was that the dollar weighted MER for just mutual funds rose from 1.93 percent in 1995 to 2.13 percent today. That's just 1/3rd of the increase noted previously. But there were factors at work over that eight-year period which can explain all of the difference in fees.

New fund companies

Many new companies emerged over the past eight years. Some have been quite successful while others have not. But the common denominator is that nearly all carry high fees for the first few years. Also, many engage the services of outside money managers to run their funds - opting this way instead of creating a new in house management firm.

These new trends tend to result in rising costs. Why? New companies need to be competitive when entering an established market. To be competitive on the quality of product, they may engage the service of an established, successful money manager. Such a high quality manager would typically command a much more significant fee than it would cost a firm to build its own.

But if a firm is to attract new money, it must offer competitive commissions to financial advisors who are paid by commissions - which cost money. The cost of commissions is typically built into the fund MERs. Read this older article about the challenges Scudder Canada faced in this regard.

Specialty funds

Specialty funds include those with a sector focus or with an emphasis on special categories of assets. All specialty funds carry higher MERs as compared to funds covering broader classes of assets. For instance, a gold fund tends to cost more than a broad Canadian stock fund.

Recall in 1999 and 2000 that new funds were seemingly launched weekly tied in to the technology boom. But it's not just tech funds. Thanks to the soaring price of gold and other commodity prices, there are now more triple the number of gold and resource funds as compared to eight years ago.

How many labour sponsored investment funds (LSIFs) and hedge funds do you think were in existence in 1995? There were fewer such funds than the number of fingers on both of my hands. Today, there are more than 130 if both categories are counted with billions of dollars in assets.

The bottom line is that the proliferation of many types of specialty funds has played a notable part in pushing up fund MERs because all carry substantially higher fees than "regular" funds.

MER calculation changes

Prior to the year 2000, GST and certain other items (i.e. interest costs) were not included in the calculation of fund MERs. Such items were always charged (and hence, factored into the daily unit price and published returns), but they were simply excluded from the calculation. National Instrument 81-101 changed the calculation of MERs by including all items on a fund's statement of operations.

While the Morningstar study acknowledges this fact, they make no effort to factor GST into the older figures. Adding GST to the 1995 average MER of 1.93 percent would bring the figure to 2.07 percent. That's still lower than today's figure, but increased regulatory costs and other factors noted in this article can account for all of the difference noted - and then some.

The real deal

I don't have access to the data used in the Morningstar study but I believe they did a valid job, despite the heavy criticism lobbed at it by industry executives. If I did a similar study (which I might) comparing dollar-weighted MERs, I would control for such factors as the specific fund type and MER calculations. And I'd be willing to bet that the trend wouldn't be rising at all - but that it would be flat or declining.

One could argue that an industry that has increased threefold should be sharing some of its cost savings with the people whose money has fuelled its growth. And I'd agree wholeheartedly.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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