Mutual funds: Let the great fee revolt begin

How to save on fees with exchange-traded funds.

It’s not much fun to be a mutual fund manager these days. In the late ’90s, money seemed to fall from the sky into the coffers of fund companies, as investors shovelled cash into whatever new product the industry threw up. But those days seem done, at least in the United States, in the wake of a string of mutual fund scandals. Anecdotal evidence suggests some mutual fund investors are beginning to move their money to alternative investment products, most notably exchange-traded funds. “My U.S. colleagues tell me we’ve seen a huge amount of business from the scandal,” says Geri James, a principal with Barclays Global Investors Canada Ltd., a manager of ETFs. “In the U.S. there was a period right after the peak of the scandal where we were getting millions in new assets a week.”

That trend could follow here. At the end of September, an Ontario Securities Commission probe found evidence of market timing among some of Canada’s biggest mutual fund companies. And while market timing is not illegal, the perception is that it enriches insiders at the expense of retail investors, a “bad faith” move that could anger anyone with life savings entrusted to fund companies.

One big attraction of ETFs is that they are immune to market timing of the sort used by some fund companies. ETFs are baskets of stocks that track the movement of an index, and because their units trade on an exchange, investors can buy and sell them at any time. In fact, arbitrageurs trade in and out of ETFs in an attempt to exploit minute differences between the unit price and the underlying value of the index being recreated. This constant trading keeps the value of the unit in line with the real value of the underlying index. James says that’s one of the pluses of investing in ETFs.

But there is a more important reason for investors to consider shifting from actively managed funds to ETFs: to save on fees. The management necessary to maintain an ETF is minimal, as the company marketing it need only preserve the correct proportion of stocks in the basket. And because the units trade on an exchange, the “back-office” technology is lessened, as are the administrative layers necessary to keep in touch with unitholders. That allows ETFs to charge a management fee of less than 1%, as opposed to 2% or 3% at traditional funds.

Those savings can make a big difference over 20 years. By one estimate a $10,000 investment in a common Canadian mutual fund with returns of 10% a year over two decades could see almost $24,000 in management fees go to the fund company, whereas the same amount invested in an ETF would pay just over $2,400 in management fees. “There’s a growing awareness out there among investors about the cost savings,” says James. “People are getting the message.”

Studies have shown that actively managed mutual funds (as a group) underperform the indexes over time in large part because of the fees they charge. A stock picker would have to beat the market by two percent just to overcome his fees, which can be difficult in itself, before he begins adding extra value.

The number of ETFs available to investors is growing. Since the beginning of October, several new funds have been launched, including one that tracks stocks in China (see table). According to James, the assets in BGI’s family of iUnits–an ETF brand name–are up 54% this year. Over the same period, assets under management at many traditional funds have been flat or declining.

Meanwhile, ETFs may soon breach the last bastion of the mutual fund industry–active management. Right now, ETF managers don’t try to beat the index. The transparency of their funds would allow front running by other managers (a practice that involves buying up shares in front of another fund accumulating a position in the same stock, which works to drive up the price and makes the position unprofitable).

But this past August, the American Stock Exchange (home to ETFs in the U.S.), announced it was looking at the possibility of changing the disclosure regime around ETFs, which could create an environment for actively managed ETFs. The arbitrage possibilities that keep ETFs in line with index values might be decayed as a result, but the funds would still be cheaper than an actively managed mutual fund, since the ETF would still rely on the exchange apparatus for its “back office.”

Hitting the right balance between disclosure and transparency is the key, obviously, but it can be done. In Germany, actively managed ETFs have been on the market for several years. All of which suggests the doom and gloom in the mutual-fund industry might be with us for some time to come.