CRM 2’s most-discussed requirement—a dollars-and-cents representation of fees—is right around the corner. The new rules will likely make even the most hands-off clients more cost-conscious.
That means detailed questions like, “What am I paying?” and “Why do I have to pay it?” A lot of attention’s been given to trailers, but you should also expect to be peppered with fund-specific queries. That means being able to explain what’s in an MER. For most clients, that’s all they’ll want or need to know. But some will dig deeper. So, you may need to discuss another metric that figures into the price of mutual fund investing: the Trading Expense Ratio (TER).
This article will help you explain both.
The TER is calculated by taking the sum of all the fund’s transaction costs and dividing it by the average value of fund assets for the annual reporting period.
So, if a fund has a TER of 0.27%, it means 0.27% of the fund’s average yearly assets went to trading expenses. Those expenses include brokerage commissions the fund manager incurs when buying and selling securities, notes Terry Rountes, CFO of Funds at Mackenzie Investments in Toronto.
They also include custodian transaction fees, which are charged each time a portfolio manager buys or sell a security. Explain to clients that it’s like paying bank fees for certain transactions, such as ABM withdrawals.
Investing in global markets is much more expensive, notes Dennis Tew, head of sales compliance and business operations at Franklin Templeton Investments in Toronto, and that will be reflected in higher TERs.
Emerging and frontier market funds tend to have the highest expenses. You can tell clients these markets are less efficient than, and lack the liquidity of, developed market exchanges, so it costs more for managers to trade.
Tew adds some companies have better access to volume pricing on trades, which trims costs.
Comparing TERs of bond and equity funds doesn’t work because of the different ways these securities are traded. Commissions are embedded in a bond’s spread, so unlike equity trading commissions, they don’t factor into the TER calculation. “Someone may come to the false conclusion that [an equity fund] is more expensive,” notes Rountes, “but it’s because of the nature of the investments the fund’s buying.”
For funds that hold both stocks and bonds, make sure the ones for which you’re comparing TERs have similar allocations. For instance, a growth fund with 80% equity and 20% fixed income will have a considerably higher TER than a balanced fund with a 50% equity, 50% fixed income mix, simply by virtue of the asset allocation. (If there’s cash in the fund, it’s likely going to be used for buying. And, as far as fees are concerned, cash falls in the fixed-income bucket.)
“But let’s say you compared two balanced funds that are more closely aligned in terms of asset mix,” says Rountes. “Any differences would be dictated by the manager’s investment style.”
A manager with a buy-and-hold strategy “doesn’t go in and out of the market a great deal. So, the expectation is that he or she can incur fewer transaction costs and fewer commissions, and therefore the TER will be lower.”
The number of securities the fund holds also impacts the TER, adds Rountes. Some equity funds have 30 stocks, others 100. “The fund with more securities may result in more trading, because […] there are more positions that could go out of favour, and [the manager] will replace them with something else.”
The TER, along with Portfolio Turnover Rate (PTR), can help you judge whether a manager’s marketing fits the facts.
Say you want buy-and-hold managers who hand-pick stocks though bottom-up analysis. Consistently high PTRs and TERs could be a red flag, notes Tew.
“If [he’s] getting into more rapid turnover every year or two years, and [is] being held out as a buy-and-hold, bottom-up stock picker, the question would be, ‘Why are you finding better opportunities so quickly after making these picks?”
He notes it’s possible the manager’s making consistently exceptional choices that quickly hit her growth targets, triggering sales. When that’s the case, gains will be reflected in her fund’s performance. But if a high-turnover fund isn’t doing so well, there may be a disconnect between the manager’s buy-and-hold billing and how she actually runs the fund.
Tew adds that turnover will—and should—vary from year to year. “When you look at PTRs and TERs, don’t just look at one year to capture what the experience might be with that fund. Certain years with certain market conditions can cause more turnover than you would otherwise expect.” For instance, with sinking oil prices, managers may be selling positions they might have expected to hold longer.
Tew says advisors should explain how TERs impact long-term prospects of making money. “A lot has been written about MERs and the hurdle rate they cause, [but] rapid trading causes a level of expense [clients also] need to overcome.”
As with TERs, it’s important to be sure you’re comparing apples to apples with MERs, Rountes says. “A balanced fund with a fixed-income component typically has a lower MER than a pure equity fund. Generally, domestic equity funds should have lower MERs than foreign equity funds or even sector funds such as resource funds.” (Sector funds typically require managers to spend more time researching the differences between companies.)
Higher MERs can sometimes be worth it for clients, he adds. “If a manager is shooting the lights out in the first quartile and charging 10 or 15 basis points more in MER, you can make an argument that it’s justifiable—the return dictates it. But if the manager’s in the fourth quartile and the MER is higher, that may be a warning” (see “Tell clients when MERs are justified,” below).
A typical MER has the following components:
Tew notes the two biggest administrative costs are:
- transfer agency fees, which involve keeping track of who holds the fund, sending out statements, tax and RRSP slips, etc.; and
- fund accounting, which involves pricing securities and the fund, sending the data to newspapers and data providers, etc.
He adds that tax pushes Canadian prices well above those in the U.S. and Europe. The Canadian version of one fund he was setting the price for had to be 13% higher than the U.S. and European versions, due solely to Ontario’s HST.
Tell clients when MERs are Justified
Give clients total clarity on why mutual fund MERs can be worth the cost, says JP Burlock, portfolio manager at 3Macs in London, Ont.
Some of his clients have a mix of mutual funds, ETFs and individual securities. Given the fee difference between ETFs and mutual funds, clients want to know why he doesn’t just use ETFs.
“If we get into a bear market for a prolonged period, where stock market indices are dropping by 50%, your [index-tracking] ETF will, by definition, [fall by the same amount]. If you have high-quality, active mutual funds, [managers] are able to deviate from the index, and [as a result] won’t do so poorly.
“So, often in bear markets you don’t want ETF exposure. I don’t know when those bear markets are coming, so a blend of active and passive is often appropriate.”
His message to clients: part of the MER is to pay for expertise that allows for less severe losses during major downturns.
Burlock gives another example:
“A client may be retired and need yield. I have to look long and hard to find ETFs that provide yields that can match some of the active funds out there. Some foreign ETFs may yield 4.5%, but there’s currency risk, and [little] defense against volatility. If we can find an actively managed [mutual] fund with a higher yield net of the MER, it makes sense to [consider] it, especially if it has much lower volatility than the overall market.”
Burlock isn’t deterred by high-MER funds, as long as they perform long-term. One fund he uses has an MER of 2.64%, but it also has low volatility and a net yield of 7.5%. “For clients who need yield from a medium-risk portfolio, it’s a fabulous fund, even though it costs a bit more.”