The Canadian mutual fund industry has long been besieged by complaints that its products are too costly. For some reason, despite the industry’s technological and financial resources, efforts to prove otherwise have thus far been fairly feeble.

The criticism of the cost of Canadian mutual funds has been fostered to some extent by academic research that has examined the issue — most famously, a paper published several years ago by a trio of academics that initially suggested that Canadian mutual fund investors pay some of the highest fees in the world.

That initial finding disappeared as the first draft of that paper was revised, yet the perception that Canadian mutual funds are the world’s most expensive still persists to some degree.

The latest defence of Canadian mutual fund fees comes from another study by Toronto-based Mackenzie Financial Corp. The results of this study, published in early September, attempt to make the case that the cost of owning funds — the combined costs of managing, administering and distributing a fund — is more or less in line on both sides of the Canada/U.S. border.

Previous cross-border comparisons have focused on management expense ratios, which may not represent the all-in cost to the inves-tor, the Mackenzie study says. That’s because, while the costs of managing and administering a fund are reported similarly in Canada and the U.S., distribution costs are not.

According to the report: “In order to compare the true cost of owning a mutual fund in Canada vs in the U.S., the [cost of ownership] of mutual funds (not simply the expense ratios) must be compared, which is the sum of ongoing compensation and amortized load charges. This allows the analysis to be indifferent to the structure of [financial] advisor compensation.”

In the U.S., funds typically are sold with front-end loads, with a sizable up-front charge, and a small trailer (known as a “12(b)-1 fee”). In Canada, initial sales expenses are usually much lower — more funds are sold with a deferred sales charge, and front-end loads are often waived — but the ongoing trailer fees that fund companies pay to dealers tend to be notably higher.

When it comes to comparing fund costs in the U.S. and Canada, these different compensation structures are significant because the bulk of the distribution cost in the U.S. (the front-end commission) is charged outside the MER. But in Canada, the full cost of distribution is included in the MER. So, simply comparing average MERs from the two countries doesn’t give an accurate reading of what investors actually pay. Once you fully factor in the distribution costs, you can make a more viable comparison.

However, that is easier said than done.

The Mackenzie study didn’t attempt to compare the entire universe of funds in Canada with the complete universe of U.S. funds. Instead, the study focused solely on funds sold through advisors.

The study excluded the 25% of U.S. funds that are sold through employer-sponsored 401(k) plans (roughly equivalent to Canada’s RRSPs) and the 3% of Canadian funds that are sold inside defined- contribution pension plans.

The study also left out the portion of funds that are sold directly to investors or through discount complexes, the latter of which is much larger in the U.S. than in Canada — accounting for about 30% of retail mutual funds sold in the U.S. vs just 8% in Canada, according to the study.

The study also excluded the large portion of funds sold through banks in Canada (representing about 31% of retail fund assets), which the study called a hybrid of direct sales and advice.

The study’s authors then whittled the comparison down further to the 30 largest fund managers in the U.S., and the 16 largest fund managers in Canada in 10 different asset classes, which, the study says, represent about 80% of assets under management in each segment (totalling 350 Canadian funds and more than 1,000 U.S. funds). Drawing on fee data from these firms, which is weighted by AUM, and assuming a five-year holding period, the study’s authors calculated the average cost of ownership for the various asset classes.

The conclusion: “The vast majority of investors in Canada and the U.S. incur a comparable cost of ownership when purchasing mutual funds with the assistance of an advisor.”

On this basis, the study found that the average cost of ownership for a Canadian domestic equity fund, sold through an advisor, for an account worth less than $100,000, is 2.27%. This rises to 2.38% if you include the GST (and provinces with an HST would add another 10 basis points to the overall cost).

How does this stack up against the U.S. average? That’s not entirely clear. The study doesn’t report an average ownership cost for U.S. funds. Instead, it shows a range for individual companies, from 1.74% to 2.41%.

In other words, if you include the GST — which would seem logical, as this is a cost that Canadian investors can’t avoid — the average Canadian fund would be at the high end of the cost range given for U.S. funds, and rank as most expensive in those provinces that must pay HST.

In other asset classes, the average Canadian fund comes off a bit better. The cost of ownership in those cases falls in the middle of the range given for U.S. companies in the international equity and balanced categories, and on the cheap side for the fixed-income asset class.
@page_break@Yet it’s not exactly clear what any of this proves. For a study that goes through some effort to generate the proverbial “apples to apples” comparison between Canadian and U.S. fund costs, it is strange that the results are not presented in a comparable fashion.

At best, an investor can conclude that the cost of ownership for the average Canadian fund bought through an advisor falls somewhere within the range of costs charged by an anonymous assortment of U.S. fund companies.

Moreover, this conclusion turns on the assumption that funds are held for five years. If the assumed holding period is longer, the comparison would presumably look worse for Canadian funds — as trailer fee charges continue to add up, whereas the larger up-front U.S. commissions would be spread over a longer time period.

Conversely, for shorter holding periods, Canadian funds might look cheaper than their U.S. counterparts. Although, for shorter periods, funds sold with deferred sales charges are likely to generate hefty redemption fees, further complicating the analysis.

But, without exploring the effects of some of these complications, it’s hard to make any definitive cross-border comparisons.

Fund industry analyst Dan Hallett — who was one of the first to challenge the research suggesting that Canada has the most expensive funds in the world by pointing out a number of flaws in the methodology of that study — isn’t entirely sold on this latest research effort from the industry, either.

For one thing, Hallett, vice president and director of asset management with Oakville, Ont.-based HighView Financial Group, suggests that these sorts of comparisons should be based on market-specific holding periods, as those are actually quite different in Canada and the U.S.: “It makes sense to apply each nation’s specific holding period in an attempt to quantify the annual sales charges that investors incur.”

While the Mackenzie study uses a five-year holding period for both countries, Hallett says, the average holding period in the U.S. is thought to be three to four years, whereas, he estimates, the average holding period in Canada is six to seven years.

However, even using average holding periods isn’t entirely accurate either, he cautions, because, even if the average Canadian fund is held for six or seven years (meaning no redemption charges are levied on DSC funds), there will be investors who will have sold their funds much sooner than that, paying redemption charges as a result.

Hallett also notes that the Mac-kenzie report is silent on the cost of fee-only advice, which he believes is another area in which the U.S. industry may beat Canada in a head-to-head cost comparison.

Ultimately, Hallett says, there is a real cost gap between Canadian and U.S. funds of about 50 to 60 bps annually — a finding he illustrates by comparing the MERs of the U.S. and Canadian versions of virtually identical funds and accounting for equal trailer and 12(b)-1 fees.

This 50- to 60-bps gap that persists, Hallett believes, is partly due to tax differences: Canadians pay GST/HST, whereas U.S. inves-tors don’t pay any taxes. The gap is also partly attributable to the vast differences in scale between the two industries. Total U.S. industry AUM are almost US$11 trillion, according to the latest data from the Investment Company Institute, vs $611.5 billion, as reported by the Investment Funds Institute of Canada. The gap also partly reflects less intense price competition in the Canadian funds business.

“We’ve seen some level of competition on the operating expense components of the MER over the past several years,” says Hallett. “What we haven’t seen is competition on the management fee component — which is typically half for the fund sponsor and portfolio managers, and half for dealers and advisors.”

This is one of the ways in which embedded compensation works against investors. Arguably, advi-sors could be more aggressive in pushing fund managers on price if their own revenue wasn’t such a large component of the MER.

That said, price pressure on management fees could yet be intensifying, particularly as inves-tors appear to be facing a lower-return, slower-growth environment for the foreseeable future. Fees can represent a much bigger drag on performance when markets are stagnant or struggling, as opposed to when they are surging.

Investors shouldn’t much care whether their ownership costs are competitive with the U.S. or not, when they’re paying 2.5% to own an equity fund that’s just eking out single-digit gains; or paying 1.7% for a fixed-income fund trying to generate returns with interest rates at close to zero.

Ultimately, cross-border comparisons are little more than an academic concern. For Canadian investors, the real question is whether they are getting value from their fund managers and advisors. IE