Morningstar Magazine - February/March 2015 - 48

Spotlight: Fees

EXHIBIT 1

directly with the fund company. Some individual
investors can also invest in share classes
available to institutional investors, but this is at the
discretion of the fund company.
Wealthy investors can also use these distribution
channels. Many fund companies offer special
share classes for these high-net-worth investors.
These share classes are often cheaper than
those sold to average investors because they come
with high minimum investment requirements.

Some do-it-yourselfer funds also include trailers.
These trailers are much lower than those for
commission-based funds. The discount brokers get
that as compensation for the work involved in
listing the fund on the discount broker's platform.

We are interested in the fees charged to
regular investors, so we focus on investors using
commission-based advice, investors using
fee-based advice, and do-it-yourselfers. We also
exclude high-net-worth and institutional investors.

Administration fees include costs for bookkeeping,
legal fees, and audit fees. These costs can
differ from year to year, which results in fluctuations in the MER. To make MERs more predictable,
some fund companies like BMO Investments
and Dynamic Funds now charge a fixed administration fees. If the sum of all the administration
costs end up being higher than the fixed
administration fees, investors do not need to worry
about them. But if they are lower, investors
don't benefit.

As we discuss below, the anatomy of the fee
each of these groups pays can be very different
so it's important to distinguish fees between
each of these groups.

A fund must also pay sales tax on its annual fees.
Some fund companies offer different share
classes in provinces that charge a harmonized
sales tax (HST).

What Fees Are Canadians Looking At?

Trading Expense Ratio
While the MER is usually the most cited
expense investors pay, it does not include the
brokerage costs fund managers pay for buying and
selling securities. These brokerage costs can
be seen in the trading expense ratio (TER). In most
cases, the more trading a manager does in a
mutual fund, the higher the costs investors can
expect to see. Investors pay for these costs out of
the mutual funds' assets.

Fees Deducted by Mutual
Fund Provider
Commission- Fee-Based
Based Advice Advice

Do-ItYourself

Loads
(See footnote 4)

MER Mgmt.
Fee

Mgmt. Fee x
Can Include
Bundled
Trailer Fee

Admin.
Costs

Taxes

Trading Expense
Ratio*

x indicates there is a fee. 1 means no such fee.
*Only for equities.
Source: Morningstar

Management Expense Ratio
The management expense ratio (MER) is often
confused with the management fee. As we
will see below, these two numbers are related but
not the same. To avoid confusing readers,
we use MER when referring to the management
expense ratio.
The MER is levied annually and expressed as
a percentage of a fund's total assets. It has three
main components: management fee, administration fees, and taxes. The management fee
is the largest component of the MER. It includes
compensation to the fund provider for making
investment decisions. For investors using
the services of a commission-based advisor, the
management fee also includes compensation
for the distribution of the fund. This compensation
is referred to as a trailer fee. A portion of this
trailer fee makes it to the advisor to compensate
him or her for building an investor's financial plan.

Unfortunately, the TER does not do a good job of
capturing brokerage costs for funds investing
in fixed-income securities. That is because bonds
are traded over the counter, which means the
dealers hold an inventory of bonds that they aim to
buy low and sell high to their clients. These
dealers do not charge a commission, but that does
not mean there are no trading expenses. As
compensation for facilitating the trade, the dealer
will mark up a bond's price above where it is
currently trading, and will purchase it back at a

price below its current value. This difference
between the purchase and sale prices
(the bid-ask spread) reflects the bond fund's
trading costs. The wider the bid-ask spread, the
higher trading costs will be. This is why
many fixed-income funds show no TER even
though there is portfolio turnover.4
What Fees Do Different Share Classes Include?
As mentioned earlier, each share-class
category can include or exclude certain fees.
EXHIB IT 1 provides a summary of the fees
deducted from assets by a mutual fund provider.
Our focus here is on the explicit costs publicly
disclosed by mutual fund providers. But that
doesn't mean there aren't other costs investors
incur. For example, Jack uses a commission-based
advisor for his financial planning, while Jill
uses a fee-based advisor. Jack may pay more for

4 In addition to fees we discuss here, there are also loads. Loads are fees charged either at the time of purchase or at the of time sale of a mutual fund. They are deducted straight from
an investor's investable assets and, thus, reduce the size of the investment. The money is collected by the fund company and paid to the distributor, usually the advisor. The reason
that we excluded them from our analysis is because a study conducted by Investor Economics in 2012, and funded by the Investment Funds Institute of Canada, showed that about 90%
of funds sold between 2007 and 2011 were done so without investors paying any kind of load. Sixty-nine percent of sales were made through no-load funds; 71% of fund sales involving
a load were made through a front-load option; but in 98% of cases, the load was waived. We also exclude TERs as fixed-income funds don't disclose these costs.

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