Shop Around: Brand-name mutual funds are starting to compete on fees

If you own certain mutual funds offered by Fidelity Investments of Canada Ltd., one of the presumably happy aspects of the new year is the fact that you're now paying lower fees. Depending on the fund or funds you hold, you are in a position to save anywhere from 8% to more than 16% on so-called management expense ratios (MERs), the fees fund companies charge clients to manage their money.

When the cuts were announced late last November, dire consequences were predicted for homegrown fund companies that didn't follow suit. Some, however, were more critical, accusing Fidelity of employing a desperation tactic to stem chronic redemptions as clients left its funds for other investments. Others questioned whether the company had done anything meaningful at all.

Indeed, Fidelity's apparent conversion to the "costs matter" camp needs to be taken with a grain of salt. Yes, MERs on specific funds are now lower. But the new fees are only competitive with those of companies that, like Fidelity, sell through networks of independent dealers who work on commission -- brand-name firms like AGF Funds Inc., AIM Trimark Investments, CI Fund Management Inc. and Mackenzie Financial Corp.

Investors have good reason to shop around for alternatives. Even after the cuts, Fidelity's MERs remain above 2.25% on equity funds, and they are still higher than 1.3% on bond funds. These rates simply don't compare to those advertised by companies that bypass independent dealers and sell directly to investors. Among these firms -- such as Phillips Hager & North Ltd., McLean Budden and Sceptre Investment Counsel -- equity fund MERs range from 1.1% to 1.67%, while income fund MERs range from 0.57% to 0.85%. (These companies also save money by seldom spending on marketing. That could be why their names aren't as familiar.)

Investors looking for the lowest fees, meanwhile, should investigate "passively managed" alternatives such as exchange traded funds (ETFs) and index funds. These are low-maintenance investments from the point of view of the fund manager, as they are essentially baskets of stocks that mirror the composition of indices like the S&P/TSX in Canada and the S&P 500 in the United States. They have MERs to match their hassle-free qualities -- as low as 0.17% in the case of one of the largest Canadian equity ETFs in the country: the Barclays i60s. While these passive investments don't have the potential to beat the markets like "actively managed" funds -- such as Fidelity's, where managers pick stocks -- they produce stable returns over time at a reasonable cost.

So, given the variety of expense-minded options available, it's reasonable to ask why Fidelity's announcement generated so much attention. To explain that, we need some context. Until recently, consumers have been relatively indifferent about the issue of high MERs. After all, 2% or 3% per year seems like a relatively small number. But a look at any MER impact calculator shows otherwise. Over a typical 25-year investment time horizon, fees on a fund with a 3% MER consume roughly 50% of a nest egg. In contrast, a fund with a 1% MER consumes just 20%.

In bull markets, when funds can generate 20% a year, it's hard to begrudge the fact that those returns might have been 3% higher without the fees. The story is different when the markets aren't so exuberant. Published returns are net of fees, so a fund with a 2.5% MER yielding 10% must generate 12.5% before fees. Whether that fee is justified is a critical question that can be answered by asking not only how a fund performed relative to its rivals, but also by looking at how it did relative to its benchmark, such as the S&P/TSX index or the S&P 500 index.

The best actively managed funds will beat their benchmarks -- handsomely. But if you look at the results of all the funds on the market collectively, you'll see that their returns really only match the index. In fact, extensive market research has shown that, in aggregate, actively managed funds are the index and, therefore, achieve index-like results. An MER of, say, 2.5% may be justified when a fund strides ahead of the index. It makes little sense when returns are only a couple of percentage points better than the benchmark. And if a fund only matches an index return, then investors lose money compared to what they would have earned if they'd bought low-cost alternatives like index funds and ETFs.

When indexes started to flat-line with the arrival of the bear market in 2000, funds that were mere "closet indexers" languished. Critics complained fund companies got paid for merely trying: They got their big MERs each year, even though investors lost money. As the downturn progressed, investors became more attuned to the full impact of MERs on funds that failed to beat the indexes. Many dumped them for exchange traded funds. Others opted for hedge funds, which agressively mix long-term and short-term investment strategies to deliver returns regardless of whether the markets are rising or falling.

Still, many investors continued buying into the brand names. And they continue to do so, driven by two ideas: first, that actively managed funds can beat the market; and second, that there's value in the advice offered by dealers who sell funds.

In this group, at least, Fidelity's fee cut is big news. The company has introduced price competition to a segment of the market where it was previously absent, and investors who own the affected funds will pay less in management fees. But they aren't the only ones who will benefit. A closer look at the numbers shows investment dealers also stand to gain -- a point that was overlooked when Fidelity announced its cuts, and one that that the firm hasn't advertised.

In this context, it's important to remember that the MERs charged by companies like Fidelity cover more than investment management costs. About half of the MER goes to the advisers who sell the funds. This comes largely in the form of the "trailer fee" that the fund company pays to the dealer each year for providing advice to clients. But not all trailer fees are created equal. In the case of what are known as "initial service charge" (ISC) or "front-load" funds, in which investors pay a sales commission when they buy their fund units, trailer fees usually run around 1%. In the case of "deferred service charge" (DSC), aka "back-end load" funds, investors pay the commission only if they sell their units within a given period of time, usually seven years. The trailer fees on these funds are about 0.5% annually.

Fidelity's cuts -- 20 basis points (0.2%) for equity funds and 30 basis points (0.3%) for income funds -- apply only to its initial-sales-charge funds, the ones that pay higher trailer fees. So, dealers have a new incentive to recommend Fidelity funds. How much of an incentive? Fidelity says the cuts will cost the company $25 million in lost revenue during the first year. But not all of that money will go to its customers. Trailer fees will consume more than half.

Furthermore, Fidelity will let funds with expiring DSC schedules automatically flip to the ISC mode. Before, the process was not automatic, which meant consumers could at least chat with their advisers about any suggested changes to their holdings. Now, advisers can double their commissions without informing clients.

This begs the question whether advice to buy these funds is aligned with the best interests of clients, who might be better off with ETFs or lower-fee, no-load funds, which are sold without sales commissions. Industry observers like former regulator Glorianne Stromberg do not view Fidelity's move as a "transparent" development for an industry under pressure to disclose potential conflicts of interest in its sales channels. It's a truism that mutual funds are sold, not bought. Fidelity's clever marketing of fee cuts has created another way to perpetuate that aphorism.

MAKING MONEY -- FOR LESS: WARY OF HIGH MERs? TRY THESE OPTIONS

Index mutual funds Most big banks offer passively managed index mutual funds with MERs typically below 1%. You get exposure to major stock indices, such as the S&P/TSX and the S&P 500.

NO-LOAD, LOW-MER MUTUAL FUNDS Several firms sell actively managed mutual funds directly to investors, which keeps MERs low. Notable examples include Phillips Hager & North Ltd., Saxon Funds, McLean Budden, Mawer Investment Management and GBC Funds. ASLDirect, meanwhile, sells brand-name funds like Fidelity, but rebates trailers fees in exchange for a $30 monthly subscription fee. This can be cost effective if you invest more than $60,000.

EXCHANGE-TRADED INDEX FUNDS ETFs, or ETIFs, trade like stocks but behave like index funds. Their MERs are well below 1%. Barclays i60 iUnits, a proxy for the top 60 stocks in Canada, has an MER of 0.17%.

POOLED FUNDS Affluent investors may pool assets, and entrust the funds to a private money manager whose fees taper downward as the pool grows. Investors hold pool units, like a private mutual fund.

SEGREGATED MANAGEMENT A money manager designs a custom portfolio in which a client owns the underlying stocks directly. This is similar to a brokerage account. The difference is that the manager picks the stocks and other securities in conformity with the investment policy statement they create for the client.