Let's stop hiding the cost of mutual fund fees

Let's get to know the real mutual fund industry, not the one walking around in a fat suit.

The real fund industry has a great business model. It create pools of stocks and bonds that people of all wealth levels can use as an investment vehicle for reaching their financial goals. But the fund business has also wrapped itself in a form of packaging that makes it look more bloated than it really is.

That's a big reason why Canada's fund industry is so often criticized for having high fees. The latest round came earlier this week when the Canadian Foundation for Advancement of Investor Rights (FAIR) asked Finance Minister Jim Flaherty to add mutual funds to a Senate committee's inquiry into why Canadians pay more than Americans for various things.

That means more talk on an issue that has been talked about ad nauseam. Here's a better idea: Get the mutual fund industry to address costs by stopping the longstanding practice of including compensation for investment advisers in fund fees. Leave it up to advisers and their clients to set the price of advice.

The cost of owning a fund is measured through the management expense ratio, where almost all costs of running the fund are expressed as a percentage of assets. Included among those costs are trailing commissions, which are kind of like a salary that fund companies pay directly to advisers who sell their products and their firms.

A typical big Canadian equity fund might have an MER in the low 2-per-cent range. A full percentage point of that amount – something close to half, in other words – is accounted for by trailing commissions. Popular bond funds have MERs in the 1- to 1.5-per-cent range, with half a percentage point accounted for by the trailer.

At some point in the distant past, it probably seemed a good idea to invisibly wrap compensation for advisers into the cost of owning mutual funds. Today, this practice has contributed to two big challenges facing fund companies and the advisers who sell their products.

First, a generation of investors has been lulled into thinking there's no cost to having an adviser. They may have some idea that they're paying to own funds, but the subtleties of the trailing commission are lost on them.

Second, the fund industry has been saddled with a reputation of over-eating when it comes to fees. Studies have suggested that the basic costs of running funds in this country are hefty on a global basis. But the optics look much worse when trailing commissions are part of the picture.

So how about securities regulators doing away with trailing commissions and instead requiring advisers to set their own fees? That way, investors will know exactly how much they're paying to own funds, and how much they're paying for advice.

Separately disclosing advice and fund fees gets us more clarity on the cost of investing, but not necessarily lower fees. That's an important distinction, because FAIR's thinking on fees is that they're expensive enough to undermine the ability of Canadians to put enough money away for retirement.

More fee disclosure could give us an environment that encourages competition, though. Fund companies do currently compete on price, but the intensity level is more lawn bowling than ultimate fighting. Maybe they'll step it up if the cost of owning a fund and the cost of financial advice are made clearer.

Reforming fund fees might also help focus more attention on the small blue-chip fund companies that are already selling without trailing commission built in. In more than a few cases, funds from these companies have consistently been best in class. We might also see more intense competition between the fund industry and low-cost exchange-traded funds, which have gained popularity but still aren't threatening the mass popularity of mutual funds.

Let's not forget that the problem of high fund costs is really a matter of both fund and advice fees. Bringing more clarity to the advice side of the ledger could promote cost-saving innovation. How about graded fees – a trailing commission of 0.5 per cent for advisers who just build and monitor investment portfolios and 1 per cent for those who do financial planning as well?

Once they've set their compensation with clients, advisers would have every reason to seek low-cost mutual funds for clients. Trim the fat – it's one path to better investment returns.

Cut the fees, please

Here are five good mutual funds from companies that either pay no trailing commissions to investment firms and advisers, or a minimal one.

*Minimums may vary according to where you buy these funds - these numbers apply to purchases through online brokers. Source: Globe Investor

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