Every investor by now should know about the deleterious effect that mutual fund fees have on Canadians’ nest eggs, but the exchange-traded-fund industry in Canada also faces issues when it comes to costs.
Although ETFs are cheaper than their mutual-fund counterparts, they face two key hurdles to significant further uptake: distribution access and advisor compensation (a.k.a. trailer fees, which most ETFs do not pay).
The two are intricately and irreversibly tied for the moment, although for the sake of investors and savers that will hopefully change soon. But when mutual funds are used to overcome these hurdles, investors need to be on the look out for the added fees this entails.
ETFs at their core are underpinned by two key factors.
The first is that in the aggregate, actively managed funds generally fail to beat their benchmarks over multi-year periods.
Only 19.6% of actively managed equity funds in Canada beat their benchmarks over the five-year period ending June 30, 2014, according to the S&P Dow Jones Indices Versus Active report.
With less than a one-in-five chance of beating the passive indexing approach, the latter alternative can’t be ignored.
The other factor is that costs matter a great deal. Excessive costs reduce the amount of capital that can grow and capture market returns.
Over a lifetime of investing, tens of thousands of dollars could be left behind due to unnecessary costs. Expressed differently, your savings may run out years earlier of when they would with lower fees solutions.
As a result, ETFs are obviously the way to go, right? Unfortunately, not necessarily.
ETF providers have certainly been pushing the cost of investing down. BlackRock’s iShares Canada last March launched its Core ETFs series initiative that significantly reduced management fees, matched shortly thereafter by BMO ETFs.
More recently, Vanguard Canada reduced its already low management fees further, lowering the firm’s asset-weighted average management fee to 0.14% from 0.19%.
So why not necessarily? Because investors need to consider the overall costs of the ETF solutions they access, especially when mutual funds are used, because such products have costs that aren’t much more advantageous than that of the underperforming mutual fund they walked away from.
Also, some ancillary services offered to investors may be rather pricey. For example, a rebalancing service can cost as much as 73 basis points. Not to be picky, but that is more than 12 times the cost of the cheapest ETFs out there. Asset allocation produces the greatest returns over time, not rebalancing around it.
The end result of such packaging is that the full benefit of including ETFs within your portfolios may not accrue to you.
Overlook the fees associated with packaged ETF solutions, or the cost of ancillary services, and the benefits of using even low-cost ETFs could drastically drop.
To confirm this, look no further than the BMO Canadian Equity ETF Fund, which has an MER of 1.05%, while its primary holding (99.2% of net asset value) is the BMO S&P/TSX Capped Composite Index ETF, whose management fee is a mere 0.05%.
Over time, using mutual funds to access ETFs could be as costly as continuing to use overpriced/underperforming mutual funds.
Yves Rebetez is managing director of ETFinsight.