Investor Insight

The U.S. advantage is less dramatic when comparing similar fee structures. How Canadian firms could further narrow the gap.
By Dennis Yanchus | 18/05/11

As anyone who has looked at the issue seriously will tell you, making cross-country comparisons of the costs of mutual funds is a complicated affair. This is especially so when comparing Canadian and U.S. fund fees.

About the Author
Dennis Yanchus is an independent fund-industry analyst. Until February 2011, he was the manager of statistics and research at the Investment Funds Institute of Canada (IFIC). He holds an MA in Economics from the University of Western Ontario. He can be reached at dyanchus@gmail.com.

At US$12 trillion in assets under management, roughly 16 times the size of its Canadian counterpart, the U.S. fund market has the advantage of much greater economies of scale. U.S. funds also have a tax advantage, in that their management-expense ratios (MERs) are not inflated by sales taxes.

Even if pre-tax costs were identical, Canadian MERs would be higher because of the harmonized sales tax (HST) levied on management fees and fund operating expenses in five of the 10 provinces, and the 5% GST charged in the other five provinces and in the three territories.

Finally, as the fund industry has argued in response to continued criticism of its costs by Morningstar and others, Canadian funds are typically priced on an "all-in" basis (including advisor compensation) while U.S. funds are typically priced on an "à la carte" basis. This is commonly known as the apples-to-oranges argument.

As this argument goes, Canadian fund investors purchase their funds through an advisor on a no-load, deferred load or front-end load (commissions waived) basis rather than on the fee-based or front-end load (commissions charged) basis that is typical in the United States.

Fund distribution costs (including the cost of advice) are typically fully integrated into the fund MER in Canada, rather than being charged separately or charged as a combination of commission and trailer fee as they are the United States.

However, it is possible for McIntosh to Granny Smith comparisons to be made. We can do so by looking at the C shares of U.S.-domiciled funds, whose fee structures are very similar to the "all-in" approach typical in Canada.

C shares in the U.S. are also known as level-load shares. They are sold without a front-end commission, and provide for an ongoing trailer fee (known as a 12b-1 fee in the United States). The trailer for C shares of equity funds is typically 1%, which is what Canadian fund companies commonly pay to fund dealers whose advisors sell funds under the front-end-load and no-load options.

Fund distribution costs for C shares in the U.S. (including the cost of advice) are fully covered by the 1% trailer fee. This is essentially identical to the typical purchase option offered to the Canadian fund investor on front-end-load (commissions waived) and no-load sales.

Using U.S. equity funds, a fund category with a long history of sale and popularity in both countries, we can compare the Canadian-domiciled fund MERs to their C-share equivalents south of the border. This will give us a good sense of the true cost disparity between the two countries. (See table).

Canada-U.S. comparisons in U.S. Equity category
U.S.-domiciled
(C class only)
Canadian-
domiciled
(front-end and
no-load series)
Difference
Number of funds 438 146 292
Average fund size (US$M) 1,027 154 873
Average MER (Simple %) 1.99 2.36 -0.37
Average MER (Asset-weighted %) 1.85 2.28 -0.43
Average AUM per fund company
(US$million)
5,356 642 4,714
All data as at Sept. 30, 2010; Canadian MERs include taxes

As the table shows, on an asset-weighted basis the MERs of U.S. equity funds sold to U.S. investors were 43 basis points cheaper than those sold to Canadian investors. Taxes account for about one fourth of the difference.

The use of September 2010 data in these comparisons enabled an assumed effective tax rate of 5% to be used for the analysis. The tax impact will be greater once the HST in Ontario and British Columbia, which was implemented on July 1, 2010, is fully reflected in MERs.

Before taxes, the gap between asset-weighted MERs in the two countries narrows to 32 basis points. While this is meaningful, it is nowhere near as dramatic as has been often portrayed in cross-border studies.

We can also compare the cost of investing in domestic equity funds (Canadian equity vs. U.S. equity fund costs) on both sides of the border using the same methodology. Once again, the analysis shows that the costs of U.S.-domiciled funds are lower; this time by 30 basis points.

Canada-U.S. comparisons in domestic equity category
U.S.-domiciled
(C class only)
Canadian-
domiciled
(front-end and
no-load series)
Difference
Number of funds 438 121 317
Average fund size (US$M) 1,027 330 697
Average MER (Simple %) 1.99 2.39 -0.40
Average MER (Asset-weighted %) 1.85 2.15 -0.30
Average AUM per fund company
(US$million)
5,356 908 4,448
All data as at Sept. 30, 2010; Canadian MERs include taxes
Sources: Morningstar; fund documents

The data, using either comparison, also suggests that the pre-tax differential between the two countries is attributable mostly to differences in overall market size, average fund size and the number of funds available for sale. For example, at September 2010, there were 146 U.S. Equity funds available to Canadian fund investors with assets of US$22.5 billion, compared with 438 U.S. Equity C share classes available to U.S. fund investors with assets of just under US$450 billion.

Despite the fact that fund ownership costs in Canada and the U.S. do not appear to be dramatically different when similar fee structures and similar fund categories are compared, the negative perception of high fund costs in Canada is largely one of the industry's own making.

The Canadian fund industry's insistence on bundling the entire cost of distribution (including advice) into the fund MER is what has prevented easy cross-border cost comparisons in the first place. If more fund companies offered direct-to-client or discount-brokerage fund series with appropriately reduced trailer fees (say, 25 basis points) cross-country differences in fees would be further narrowed.

While fund companies have been afraid to make such a move in the past, due to the threat of backlash from the advisor community, times have changed. Advisors are no longer as threatened by the do-it-yourself investor, since they know that the majority of fund investors would continue to use an advisor.

Major fund companies would have much to gain if they offered their entire fund line-up in a direct-to-client version. They would win praise from the media, from long-time industry critics and, paradoxically, from the advisor community.

Such a move in no way precludes the continued sale of the firm's bundled series, just as C shares are sold alongside unbundled share classes in the United States. Finally, arguments that the "all-in" fund pricing model is one of investor demand rather than fund-company supply would be more credible if direct-to-client options were also provided.

Over the longer term, fund investors should be asking regulators to allow the sale of U.S.-domiciled funds in Canada. While a common regulatory regime similar to the UCITS system in Europe (which allows funds to be sold throughout the European Union) may not be possible between Canada and the United States, fund regulation between the two countries is not so different as to prohibit the creation of a passport system.

Such a move would give Canadian fund investors more choice and more access to economies of scale, which could only translate into further reductions in the cost disparity between the two countries.

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