Eventually, even those parties who have so far successfully resisted fee pressure for their services by lowering the cost of complementary ones will have to adapt.
This article originally appeared in the August/September 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
The publication of our Global Investor Experience Study, which looks at how well fund investors are treated in dozens of countries (see Home-Court Advantage), generated the usual protests from Canadian asset managers who dislike us shining a light on the fact that their nation’s funds sport the highest expense ratios in the world. This year, in fact, the Canadian fund association trade group, IFIC, launched an anticipatory attack by running a study seeking to show that Canadian funds aren’t as expensive as they look at first glance. The study was instructive in illuminating the balance of power between fund companies and the advisors who sell the funds. Its findings are worth exploring, although not solely for the reasons IFIC intended.
The crux of its argument is that Canadian funds bundle management fees (the fund company’s take) with distribution costs (the advisor’s take). Ignoring the fact that such arrangements are common throughout Europe (where fund-management fees average around 80 basis points and advisor fees add another 80 basis points for an average fee of about 1.6%) and deployed in C shares in the United States, IFIC argues that this makes Canadian funds incomparable with other country’s funds. They claim that Canadian fund expenses, which average more than 200 basis points, are roughly equal to those of U.S. funds if one assumes average U.S. costs of 80 basis points in management fees plus additional advisor fees of 100 to 150 basis points. Again, if one ignores the fact that C share-class funds in the United States check in at a lower level than that and that U.S. investors can opt out of the advisor’s fees more easily than Canadian investors can, it’s a fair point.
Where the case gets interesting, however, is in IFIC’s own breakdown of the fees Canadian funds charge. By its own estimates, the typical Canadian fund-management company takes 120 basis points for itself and pays the advisor 80 basis points in arriving at the 2% expenses, which raises the questions:
1. Why do Canadian fund-management companies take a 50% bigger toll than fund managers anywhere else in the world?
2. Why are Canadian financial advisors paid one third less than their U.S. counterparts?
One suspects that these weren’t the questions IFIC intended to raise, but they’re worthy of consideration. It appears that Canadian asset managers and U.S. financial advisors are paid well above global norms. How we got here appears to be a classic tale of where the relative pricing power lies. In Canada, the market is dominated by a few large management institutions. Being in control, they predictably take a big slice of the pie for themselves and allot a smaller take for the advisors needed to sell the funds. In the United States, the opposite happened. There are scores of asset managers, including low-cost ones like Vanguard, so the pricing power of managers is diffused. Instead, distributors like brokerage firms and financial advisors hold the upper hand. They’ve seized the opportunity to increase their take and drive down the share allotted to managers. The move has been amplified by the fact the Canadian study drove home—most U.S. distribution costs are outside the expense ratio. So while advisors have pushed managers’ take down by opting for exchange-traded funds or institutional share classes, they haven’t faced the same downward pressure on their less-public fees.
In the big picture, any set of fees—no matter how they are divided—that totals more than 2% is a heavy burden in the current era of lower yields and returns. Continued downward pressure on U.S. managers and Canadian advisors is likely. But fee pressure is also likely to come finally to those parties that have avoided it to date, namely Canadian fund companies and U.S. advisors. For Canadian managers, it’s already happening. ETF sales are exploding in that market and are certain to gobble up market share. For U.S. advisors, the pressure to lower fees may continue to be postponed by offsetting the advisor fees with fee cuts from moving to passive and institutional shares. But, in time, a generation of clients that has been wooed by advisors promoting their use of low-cost vehicles is likely to create clients who begin to apply the same logic to what they pay their advisor. As client assets grow and the balance of power shifts to the client, U.S. advisors are likely to face more demands for lower fees, especially on higher balances. The smartest clients will demand to pay in dollars, not in basis points.
Eventually, even those parties who have so far successfully resisted fee pressure for their services by lowering the cost of complementary ones will have to adapt. Twenty years from now, there’s no way Canadian fund managers will be able to charge fees north of 1%. The same goes for U.S. advisors.