Fund Investing

Breaking down the full cost of fund ownership
By Morningstar Canada | 24/02/15

Editor's note: Today's concluding installment of a two-part series on fund fees in Canada focuses on the components of the full cost of fund ownership. The series is based on findings originally published in the February/March issue of Morningstar magazine. The research was conducted by a three-member Morningstar Canada team consisting of Paul D. Kaplan, director of research, and including manager-research analyst Achilleas Taxildaris and former analyst Salman Ahmed.

About the Author
Morningstar Canada, a subsidiary of Morningstar Inc., is a leading provider of independent investment research and data. We provide extensive reporting, analysis and commentary on investments and personal finance. The editorial team can be reached at feedback@morningstar.com with your comments and questions, but we cannot provide personal advice.

The management-expense ratio (MER) is often confused with the management fee. These two numbers are related but not the same. The MER is levied annually and expressed as a percentage of a fund's total assets. It has three main components, of which the largest is the management fee. The other two components are expenses and/or administration fees, and taxes.

The management fee includes compensation to the fund provider for making investment decisions. For investors using the services of a commission-based advisor, a portion of the management fee is payment to the brokerage or fund dealership for distribution of the fund and ongoing service to the investor. This compensation is referred to as a trailer fee. A portion of the trailer fee is paid to the advisor as compensation for personal advice and service.

Some fund classes that are designed for do-it-yourself investors also pay trailers to distributors. However, these trailers are much lower than those for commission-based funds. The discount broker gets that discounted trailer as compensation for the work involved in listing the fund on its platform and for order execution and account administration. (For an overview of the various distribution channels for mutual funds, please read part one of this series.)

Operating expenses charged by funds include costs for bookkeeping, legal fees and audit fees. These costs can differ from year to year, resulting in fluctuations in the MER. To make MERs more predictable, many fund companies now charge fixed administration fees. If the sum of all the administration costs end up being higher than the fixed administration fees, investors do not need to worry about them. But if they are lower, investors don't benefit.

A fund must also pay sales tax on its annual fees. These fees consist of the 5% goods and services tax (GST) or equivalent, plus the provincial or territorial sales tax. While provincial sales-tax rates vary widely, most fund companies apply common tax rates to their funds. Exceptions include a few companies that offer lower-cost fund classes designed exclusively for residents of Alberta, where there is no provincial sales tax.

While the MER is usually the most cited cost that investors pay, it does not include the brokerage fees that fund managers pay for buying and selling securities. These costs can be seen in the trading-expense ratio. In most cases, the more trading a manager does in a mutual fund, the higher the costs investors can expect to see. Investors pay for these costs out of the funds' assets.

Unfortunately, the trading-expense ratio does not do a good job of capturing brokerage costs for funds investing in fixed-income securities. That's because bonds are traded over-the-counter, which means the dealers hold an inventory of bonds that they sell to clients.

In lieu of charging commissions on clients' bond purchases, dealers will mark up a bond's price above where it is currently trading. When the client is ready to sell, the dealer will buy the bond back at a price below its current value. This difference between the purchase and sale prices (called the bid-ask spread) reflects the bond fund's trading costs. The wider the bid-ask spread, the higher the trading costs. This cost is borne entirely by investors, even if it isn't reflected in the trading-expense ratio.

Our focus here is on the explicit costs publicly disclosed by mutual-fund providers. But that doesn't mean there aren't other costs that investors incur. For example, Jack uses a commission-based advisor for his financial planning while Jill uses a fee-based advisor. Jack may pay more for the share class he buys but that's because the mutual-fund fee will already include compensation paid to the advisor.

Conversely, Jill pays less for her fund, but that's because she will have to pay her advisor out of her assets to compensate the advisor for his/her services. Do-it-yourselfers may also have to pay transaction costs not included in any initial sales charge, the MER or the trading-expense ratio. For example, some discount brokers may charge a registration fee for opening up an account or an annual fee for administering the account.

Within each asset class, MERs of commission-based shares are higher than those of the other two distribution channel's shares. The main reason for this is the bundled trailer fee, which helps compensate advisors. Investors using fee-based advice still pay for the services of their advisor but this fee isn't already included in the MER. In fact, the difference between the commission-based MERs and fee-based MERs is roughly the amount of the average trailer for the equity asset-class groups.

Investors can use these findings as a benchmark for fees they are paying. If an advisor puts an investor in a fund with a higher-than-average MER relative to the same asset-class group within the same distribution channel, the investor should probe whether the fund has the ability to hurdle that fee difference. Additionally, if an advisor suggests funds with a higher-than-average trailer, investors should be asking themselves whether the service the advisor provides is deserving of this higher compensation.

We calculated the asset-weighted average MERs in each distribution channel by broad asset class. The results for domestic core bonds, domestic core equity and domestic noncore equity funds are as follows:

Asset ClassCommission-BasedFee-BasedDo-It-Yourself
Domestic Core Bonds1.6%0.8%0.6%
Domestic Core Equity2.1%1.1%1.1%
Domestic Noncore Equity2.6%1.6%1.6%

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