Dale Jackson

Personal Finance Columnist, Payback Time

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It’s no secret Canadian mutual fund fees are among the highest in the developed world. Not all mutual funds are expensive and in many cases, those hefty fees are justified by strong performance. But data over several time periods shows the average equity mutual fund slightly underperforms its benchmark once fees are added. As if that isn’t curious enough, the holdings and weightings in many funds are strikingly similar to their benchmarks.

It suggests an under-the-radar practice called “closet indexing” -- when mutual fund managers claim to be actively managing the individual holdings in their portfolios but are merely duplicating the underlying index.

It allows them to post returns comparable to the index, while reaping big fees. Annual fees on equity mutual funds, expressed as the management expense ratio (MER), often exceed two per cent of the total amount invested. In comparison, annual fees on market weighted exchange traded funds (ETFs), which track their indices directly, are often well below half of a per cent. 

Most Canadians save for retirement through mutual funds because they are the only way for average investors to access a diversified, professionally managed portfolio. But mutual fund fees can add up to thousands of uninvested dollars, which could have compounded into hundreds of thousands of dollars over time.

THERE’S NO WAY OF KNOWING FOR SURE

The opportunity for closet indexing exists under a veil of secrecy because mutual fund companies are not required to disclose a heck of a lot about their portfolio holdings. Most fund providers will post a few top holdings and their weightings every few months but it’s almost impossible for average investors to get an accurate, up-to-date, picture.

The asset class ripest for closet indexing are Canadian equity funds - a staple in every retirement portfolio. The top holdings disclosed in just about every fund in the category include the same big Canadian banks, telcos and resource-related companies that make up the S&P/TSX Composite Index. 

BAY STREET’S DIRTY LITTLE SECRET

So, why would your trusted investment advisor recommend a Canadian equity mutual fund over an ETF? Better yet, why not just buy the few big TSX-listed stocks directly?

Some Canadian equity funds are actually actively managed and beat the index on a regular basis but the answer is rooted in how that advisor is compensated. In most cases a commission, or “trailer fee” is baked into the MER. It is an annual reward from the mutual fund company to the advisor for choosing their fund for the client.

The trailer fee can vary but is normally about one per cent of the total amount invested. In a $500,000 portfolio of mutual funds the trailer fee would add up to $5,000 each year for the advisor. 

Officially, the trailer fee is intended to compensate the advisor for “ongoing advice” but there is always the temptation for that advice to be for the client to remain in the fund that gives the advisor the highest commission.

HOW TO STEER CLEAR OF A CLOSET INDEXER

In some cases, the person you think is an advisor is actually a mutual fund vendor who is only qualified to sell mutual funds. Regulators are working toward a formal definition but for now just about anyone can call themselves an advisor.

The best advisors are qualified to invest in anything; mutual funds, ETFs, stocks, bonds, options. Qualified, experienced advisors know the best mutual fund managers who actually manage their portfolios and can determine when, or if, an ETF or direct investment is a better option.