Morningstar's latest study shows Canada still among the worst countries in terms of cost competitiveness
From the perspective of investment product innovation, Canada has plenty to be proud of. After all, it’s the birthplace of the ETF, the first bitcoin fund, the first pension mutual fund, as well as other world-leading products. But when it comes to fund fees, there’s still some progress to be made.
In the most recent addition to its Global Investor Experience (GIE) study, Morningstar examined the experience of mutual fund and ETF investors around the world through the lens of fees and expenses as of 2021. Specifically, it looked at the asset-weighted median expense ratio of different categories of funds – asset-allocation funds, equity funds, or fixed-income funds – by country or market, focusing on share classes that are available to retail investors.
In the latest study, Canadian funds consistently landed among the six worst markets out of 26 studied in terms of asset-weighted median expense ratios paid. According to Ian Tam, Director of Investment Research, Canada at Morningstar, part of Canada’s continued weakness in terms of cost-competitiveness stems from its primarily bundled-fee environment for investment funds.
“In the Canadian bundled-fee environment, the investor pays for advice as well as distribution as part of the MER,” he told Wealth Professional in a recent interview. “The trend towards fee-based advice is continuing very quickly, but the majority of assets still sit within commission-based share classes of funds.”
As Tam emphasizes, Morningstar’s study looks at what investors pay for investment funds without distinguishing whether the cost of advice is embedded. In that sense, the study isn’t exactly making apples-to-apples comparisons, and markets like Canada end up getting penalized compared to others. But that system also reflects Morningstar’s stance that not bundling the cost of advice in the cost of an investment fund is preferable.
“In bundling the cost of advice into the MER of investment funds, you raise the risk of an investor receiving poor advice or possibly no advice at all,” Tam says.
For asset-allocation funds, Canada had the worst performance: the asset-weighted MERs for those products in the country was around 1.8%, compared to just around 0.6% for the U.S. and just over 0.8% for the U.K. That, according to Tam, is more of a natural offshoot of Canada’s bias toward having assets in balanced or asset-allocation funds.
Of course, things could be changing. As Tam notes, the know-your-product rules of the client-focused reforms imposes two levels of responsibility with respect to the cost of investment products. At one level, it requires advisors to perform due diligence on the funds they recommend, which includes documenting that they’ve compared a reasonable range of alternatives to arrive at their final recommendation.
“They have to pick a number of comparable funds, and record why they chose the fund they did,” Tam says. “Under the KYP rules, the impact of fees over time is explicitly stated as one of the required considerations. So if a higher-MER fund has a record of performing poorly relative to other alternatives, it’s very difficult for the advisor to objectively recommend the more expensive fund without some form of recorded explanation.”
At a higher level, the KYP rules also require a firm to monitor the product shelf they approve for their advisor teams for significant changes. As part of that process, Tam says the hope is that the ones in charge of overseeing the shelf will take a closer look at whether all the products belong there, or whether they can create a reasonably equivalent range of options at a lower cost.
Another crucial element of the CFRs, he says, is the conflicts of interest rule as it pertains to in-house fund products. Under that piece of regulation, firms that use proprietary products must perform regular competitive analysis of their products against others in the market. That includes not just performance, but also costs.
“Let’s say you're a large, vertically integrated financial institution, which many firms in Canada are,” Tam says. “You now have to ensure that your proprietary products are just as competitive as what else is in the market. And when you think competitive, that certainly means that cost and fees are going to be part of that analysis.”
Given the events in financial markets over the past couple of years, some have suggested that higher-cost investment products like active funds and alternatives are set to have their moment in the sun. If investors put a larger part of their portfolios in such strategies, that could move the needle back in terms of asset-weighted MERs. But in Tam’s view, that’s not likely.
“If we’re talking about alternative funds, they tend to come with a higher degree of risk, so they will likely make up a smaller portion of a typical investor’s portfolio. The broad majority of Canadians will probably put their assets in fairly traditional mutual funds,” Tam says. “We know all about the academic studies pointing to fees as the single consistent determiner of long-run performance, so I don’t think investors should ever take their eye off fees.”