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Coming Soon – More Information for Investors

Client Relationship Model – Phase 2 (CRM2)

The Canadian Securities Administrators (“CSA”) implemented changes to securities legislation in2013 to provide investors with more and clearer information about the performance of their investments and the fees they are paying. At the heart of CRM2 is the objective to give investors the information they need to understand how their investments are growing and what they are paying for the services related to managing their account.

The first two phases have been implemented and the third is effective July 15, 2016. This is the one that scares most dealers in the mutual fund world because most investors who purchase retail mutual funds have no idea how much they are paying in fees. The changes are going to apply to all retail investments you purchase through a bank or a mutual fund company. Retail segregated funds available through insurance companies are exempt (for now).

All fees charged to your account by the dealer’s firm will be expressed in dollars (not percentages) – whether those charges were visible to you or not. By the end of 2016, investor statements will go through some transformations as consumer-friendly reporting of performance and costs, expressed in dollar terms, becomes mandatory.

Even though the requirement is effective July 15 of this year, the mutual fund dealers have one year to implement it, so don’t expect changes to occur overnight. However, since most mutual fund dealers operate on a calendar year basis, most investors will see the information in all likelihood starting early in 2017 for the year ending December 31, 2016.

Some of the dealers are saying this is no big deal. The clients already know how much they are paying. I have to say that most people I work with are surprised when the fees they are paying are explained to them in plain language. The management expense ratio (or MER as it’s often called), is typically described to the investor in percentage terms and it is available, but often only after a fair amount of digging. An MER of 2% or 3% doesn’t sound like much in the grand scheme of things but it certainly adds up year after year.

If you invest $10,000 per year and earn 5% without fees, you would have $132,000 at the end of 10 years.  If the MER was 2%, you would have $118,000 at the end of 10 years.  The fee in year 10 would be almost $2,400.

In any event, most investors have no idea how much they are paying for the “advice” they get from their mutual fund advisor or the person sitting across from them at the bank. Nor do they know how much the advisor gets for the various funds sold. The new law will require disclosure of the dollar amount paid to the firm. It unfortunately, still doesn’t show how much is paid to the actual advisor by the dealer. The total expenses are still not being disclosed, just the fees paid to the dealer firm. And the fees will be for each account without any breakdown by specific fund in the account. So, the client will still not know how much extra the advisor is getting for the money you may have sitting in the global equity fund versus the Canadian government bond fund, for example.

Advisors who actually provide a reasonable amount of service to their clients probably have nothing to worry about, but those advisors who sell the funds and sit back and watch the fees roll in might have some explaining to do once the fees start appears on the statement. After the initial sticker shock, some investors may decide that they can pursue a low cost route by using a fee-only advisor or by doing it themselves with ETFs.

Of course, seeing the fees come out of the account during times when the investments are dropping in value will be a major irritant for some clients. It is already happens to investors since the dealer and advisor get paid during good times and bad times – it’s just not noticeable to the investor.

The reports will provide the investor’s personal rate of return, but reporting of benchmarks will not be not required. As a result, the investor won’t know (without additional research) how well the portfolio performed relative to relevant benchmarks. This is important because if your portfolio went up by say 5%, you’re likely reasonably happy, but if the fund’s benchmark (i.e. what it’s measured against) goes up by 8%, then your portfolio didn’t do as well as it perhaps should have and you should ask questions to ensure you understand why and to ensure your investment advisor is actually providing value for the fees charged.

Obviously, the more information that is provided concerning fees and performance the better. One extra upside is that investors who may have been reluctant to call their advisor for risk of “bothering” them may now feel rightly justified in contacting the advisor with any questions they have or if they need any information.

The change in the law goes a long way towards providing information to investors so they can evaluate the service, fees and performance of their advisors but investors are not off the hook – they’ll still need to do their homework.

Never Trust a Pretty Picture

A graph a lot like this one appeared in one of our national newspapers recently in an ad for a mutual fund. At first glance, it looks like this fund has consistently outperformed the index that it’s measured against.  It has increased by a whopping 194% since early 2000 compared to what it’s measured against, which increased by a paltry 51%.

Chart 1:
Chart 1

I’m not really sure what that means.  Both went up in value over the period so capital was preserved.   Obviously, they want you to focus on the fact that they earned 194% over the roughly 16 years and the MSCI World Index only returned 51% over the same period.  It sure looks like the fund did better over the whole period.  It’s going up a lot faster since the 2008 financial crisis and down less before.  This chart is an example of one of my pet peeves. The ad said “The quality advantage: Capital preservation contributed to long-term performance.”

The type of chart they’ve used is called a linear chart.  They do not give a clear picture of long-term investment growth.  A log chart, on the other hand, shows what investors really want to know.  I know logs (logarithms) scare most people because of the trauma they endured in trying to learn about them in high school.  All you need to know is that:

  • With a linear chart (see Chart 1 above), an equal increase along the vertical axis (left side of the chart) represents an equal increase in the dollar amount. This means that the increase from 50 to 100 looks the same as the increase from 250 to 300.  They are the same amount, but not the same percentage.
  • In a log chart (see Chart 2 below), an equal increase along the vertical axis represents an equal percentage increase. What this means is that the increase from 50 to 100 is the same as the increase from 150 to 300 – they both doubled.  This is what most investors are really interested in.  An investor who earns $5,000 on his $10,000 investment will be a lot happier than the investor who earns $5,000 on his $100,000 investment over the same period of time.  I’ve recreated the chart, but this time using a log scale on the vertical axis so we can get a more accurate picture of how well this fund did in relative terms.

Chart 2

chart 2 fin

This is also an excellent example of how past performance doesn’t predict future performance.  Someone looking at the performance of the advertised fund after the first two years covered in the chart would have thought, “Holy cow, the fund earned 50% over the last few years and the index lost 50%.  I gotta get me some of that fund.”  They would have been disappointed over the next 14 years since they would be paying fees for a fund that was supposed to perform better than the index, when in reality, this wasn’t the case at all.   With the exception of the first couple of years, you can see that the blue and red lines follow each other very closely.  This means, since part way through 2002, the fund and the index it’s measured against have earned the same percentage return.  In fairness, the fund out performed big time for the first couple years, despite the tech bubble bursting at that time.  So, maybe that’s the preservation of capital they were talking about in the ad when describing the fund.  You can see that in Chart 1 above too,  if you analyze it carefully, but it’s not obvious.  You have to look closely – really closely.  For example, after the tech bubble burst in 2002, the fund being advertised and the benchmark it’s compared to have both almost exactly tripled.  If you look at the financial crisis in 2008, they both lost about 50% of their value, so capital wasn’t preserved very well that time by either the fund or the index.

Things aren’t always as they appear.  It’s important to look beyond the pretty picture to understand what it’s really telling you – or just as important, what it’s not telling you.