There has been an ongoing debate in both the media and in academia
about the value Canadian mutual funds produce for the people who
invest their savings through these vehicles. With Canadians now
entrusting $646 billion of their savings to mutual fund managers,
the outcome of this debate is not inconsequential.1
Thus far, the debate stands unresolved, with Canada’s mutual
fund industry successfully parrying the cuts and thrusts delivered
by the industry’s critics over the years.
An important reason the debate has not been resolved is because
there has not been a standard definition of the value mutual funds
are supposed to deliver to their customers. If the debate is ever
to be resolved, a clear value definition that all parties can agree
on will first have to be established. Once established, the debate
can finally be resolved through the measurement of actual outcomes
against this value standard. Such measurement should ideally be
done with databases that are large, and of verifiable quality.
The study described in this article meets these criteria. It starts
with an operationally useful definition of value (see above), and
includes a specific something else that can act as the suitable
equivalent value benchmark. We propose the comparable investment
results delivered by a large sample of Canadian pension funds as
the equivalent value benchmark. If Canadian mutual funds provide
fair value, they would deliver equal or better investment results
than Canadian pension funds deliver with similar investment mandates.
The study specifically compares the net excess returns produced
by a large sample of Canadian mutual funds with domestic equity
mandates against the net excess returns produced by a large sample
of the domestic equity components of Canadian pension funds. An
important study finding is that, over the nine-year period from
1996 to 2004, the Canadian equity components of Canadian pension
funds outperformed their Canadian equity market benchmark by an
average +1.2% per annum, net of expenses. Over the same nine-year
period, Canadian equity mutual funds with domestic mandates underperformed
their Canadian equity market benchmark by an average -2.6% per annum,
net of management fees, but before any applicable sales charges.
Any such sales charges would reduce mutual fund net returns even
The measured Canadian mutual fund average return shortfall (before
sales charges) of 3.8% per annum relative to similar mandates executed
by Canadian pension funds suggests the average Canadian mutual fund
has not been producing fair value for its customers.
Study databases, methodology, and results
The source of these findings is a study commissioned by
the Rotman International Centre for Pension Management (ICPM) at
the University of Toronto. The study titled “Economies of
Scale, Lack of Skill, or Misalignment of Interest? A Study of Pension
and Mutual Fund Performance” by Bauer, Frehen, Lum, and Otten
was first presented at an ICPM Workshop in October 2006, and can
be accessed through the ICPM website.2
The mutual fund data came from website Globefund.com and the Worldscope
databases (for Canadian funds) and the CRSP database (for U.S. funds).
The pension fund data comes from the databases of the global benchmarking
firm CEM Benchmarking Inc. CEM has return, benchmark, and expense
data for Canadian and U.S. defined benefit (DB) pension funds starting
in 1992, and for U.S. defined contribution (DC) pension funds starting
A key metric in the study was Net Value Added (NVA), which is calculated
in two steps. A fund’s gross return minus the return on the
relevant market benchmark over the same period is defined as a fund’s
Gross Value Added (GVA) over that period. GVA minus the fund’s
management expense ratio (MER) over the same period is defined as
a fund’s NVA over that period. Table 1 on the right reports
the average GVAs, MERs, and NVAs for the domestic equity components
of large samples of Canadian and U.S. mutual funds and pension funds.
Each analysis was performed using the maximum available data for
the specified time period.4
Thus the Canadian DB92 NVA averages are based on annual observations
beginning in 1992 and ending in 2004. The Canadian mutual fund (MF)
data starts in 1996, hence the Canadian DB96 NVA average is also
calculated to provide a more direct comparison with Canadian MF96
NVA averages. The U.S. DB NVA averages are based on the 1992-2004
period, thus there are U.S. DB92 and U.S. MF92 calculations. The
U.S. DC NVA averages are based on the 1997-2004 period, leading
to U.S. DC97 and U.S. MF97 calculations. Other metrics in the tables
are the number of annual fund observations (N) on which each of
the calculated averages are based, the standard deviations (SD)
are metrics indicating the degree of dispersion around the calculated
NVA averages, and the TStats are measures of statistical significance
of the calculated NVA averages, with values greater than +2 or less
than -2 indicating strong statistical significance.
We summarize the key study findings summarized in Table 1 as follows:
- The average Canadian pension fund participant received positive
value from domestic equity investments, both over the 1992-2004
(DB92 NVA=+0.76%) and 1996-2004 (DB96 NVA=+1.23%) periods. This
included the deduction of an average 0.25% per annum for incurred
investment expenses. In contrast, the average participant in Canadian
domestic equity mutual funds over the 1996-2004 period gave up
considerable value (MF96 NVA=-2.60%). This loss was entirely due
to the average 2.75% per annum in incurred investment expenses.
Any incurred sales charges would make the value-loss even more
- The average U.S. pension fund participant received marginally
below market-equivalent performance from domestic equity investments,
both over the 1992-2004 (DB92 NVA=-0.12%) and the 1997-2004 (DC97
NVA=-0.44%) periods. This included the deduction of an average
0.32% for incurred investment expenses in the DB funds. The average
0.62% deduction for the DC funds includes administrative expenses
as well. In contrast, as in Canada, the average participants in
U.S. domestic equity mutual funds over the 1992-2004 and 1997-
2004 periods gave up considerable value (MF92 NVA=-2.78%, MF97
NVA=-2.53%). Part of this loss was due to higher investment expenses.
An even greater part was due to the average U.S. domestic equity
mutual fund underperforming its benchmark even before expenses.
Any incurred sales charges would make the value-loss even more
severe. Are there explanations for these findings?
Possible explanations for the findings
Why would Canadian mutual fund investors subject themselves
to an average wealth-loss of 3.8% per annum relative to implementing
the same basic investment policy through Canadian pension funds?
Or equivalently, why would Canadian mutual fund investors pay an
average 2.75% (or more including sales charges) for an investment
service that is available to Canadian pension fund participants
for an average 0.25%, and which produced inferior investment results
even before the far greater expenses? A number of possible answers
come to mind:
- DB pension fund expenses are understated: this is in fact the
case. However, even if additional costs related to such functions
as oversight, custody fees, and other administrative costs were
added to the pension fund domestic equity investment expenses
of 0.25%, the total expense ratio might rise to 0.40%.6
A 0.15% reduction in the calculated average pension fund NVAs
in no way affects the study’s basic findings.
- The pension fund results suffer from a positive selection bias
and/or risk/style biases: the researchers tested for these possibilities
and found (a) the CEM database covers 70% of all Canadian DB plan
pension assets, and (b) no overall risk/style biases in either
the equity components of the pension funds, or in the equity mutual
funds. Another possible bias might be that the cited study only
compared Canadian equity mandates and not, for example, broader
balanced fund mandates. The problem there is comparability. For
example, pension funds invest in such asset classes as private
equity, real estate, and hedge funds, while mutual funds with
balanced mandates do not.
- Only 40% of Canadian workers have access to pension fund management:
this is in fact the case. With only 40% of the Canadian workforce
covered by an occupational pension plan, the other 60% has to
fend for itself. However, this fact by itself cannot explain why
Canadian investors in domestic equity mutual funds pay an average
annual fee of 2.75% (plus sales charges in many cases). For example,
exposure to domestic equities could be acquired by buying and
holding exchange-traded funds (ETFs) for a small fraction of the
fees Canadian investors pay to mutual funds.7
- Mutual funds are sold, not bought: the market for investment
management services is highly asymmetric, with the buyers of these
services knowing far less about what they are buying than the
sellers know about what they are selling. Information economics
predicts that in such a market buyers will pay too much for too
little. Research results from the field of behavioural finance
support this conclusion. This research shows people to be generally
unsophisticated, inconsistent, hesitant, and even irrational regarding
financial matters, which creates the opportunity for the for-profit
financial services industry to proactively step in and sell their
products and services at too-high prices.8
The veracity of his third explanation is supported by the findings
of a recent survey of 1865 Canadian mutual fund investors. When
asked why they had bought mutual funds, 85% said they were persuaded
by “someone who provided me with advice and guidance.”9
In our view, it is the combined effects of informational asymmetry
and behavioural dysfunction on the part of the customers, and
opportunistic acuity on the part of the suppliers, that best explains
the findings summarized in Table 1. Mahoney (2004) reaches similar
conclusions in a paper titled “Manager-Investor Conflicts
in Mutual Funds.”
Indeed the consequences of this toxic combination of naïve
mutual fund buyers and clever mutual fund sellers are materially
worse than the numbers in Table 1 suggest. A U.S. mutual fund study
based on 1985- 2004 data published in Jack Bogle’s book “The
Battle for the Soul of Capitalism” found that the average
U.S. equity mutual fund under performed the market by the same 2.8%
that we reported in Table 1. However, individual investors under
performed the average experience of the mutual funds they invested
in by a further average 3.3% per annum. Why? Because many mutual
fund investors switch from fund to fund in search of better performance,
thus falling into the typical naïve investor “buy high,
sell low” trap, and in the process generating further unrewarded
sales and transaction expenses.10
We conclude with some thoughts about the implications of our findings.
To fully appreciate the impact and consequences of these findings,
consider a Canadian worker earning a constant $50,000 per annum
over a 40-year working life. A sum of $10,000 per annum is saved
for retirement. The retirement fund earns a pre-expense 3% real
rate of return over the 40-year period. At the end of the 40-year
period, a 20-year annuity is bought with an embedded interest rate
of 1.5%. Table 2 sets out the annual pension this worker will receive
with investment expense ratios of (a) 0%, (b) 0.4%, (c) 1.5%, (d)
3%, and (e) 5%.
|Table 1 suggests that a 0%-0.4% ratio range is realistic for
Canadian pension fund experience, depending on whether the average
Canadian pension fund continues to offset its investment expenses
with excess returns over market benchmarks.11
The 1.5%- 5% ratio range covers the wide range of possible expense
ratio experiences for Canadian mutual fund investors. The 1.5%
ratio is at the low end of the range, and assumes the investor
does not engage in the kind of “buy high, sell low”
activity that Bogle describes in his book. The 5% case assumes
expense ratios at the high end of the range, as well as active
engagement by mutual fund investors in the further wealth-reducing
behaviours described by Bogle.
|Table 2 indicates that under realistic assumptions, the typical
mutual fund investor faces a minimum pension reduction of 22%
(i.e., from $41,000 per year to $32,000 per year) relative to
the typical pension fund participant (i.e., with a mutual fund
expense ratio of 1.5%, and a pension fund ratio of 0.4%). That
pension reduction grows to 64% if we push the mutual fund expense
ratio up to 5%, and offset the pension fund expense ratio of
0.4% with an equivalent amount of pre-expense excess return
(i.e., the pension reduction now is from $45,000 to $16,000
per year). From a different perspective, if we apply the calculated
annual net return shortfalls directly to the $646 billion Canadians
have invested in mutual funds, their collective value loss is
somewhere between $7 billion and $32 billion every year.
Public policy implications
The preceding financial analyses suggest that the vast majority
of the 60% of the Canadian workforce who are not members of occupational
pension plans will have a very difficult time generating adequate
pensions by investing their retirement savings through the mutual
fund sector. This is so despite the very high 20%-of-pay savings
rate assumed in the example. The sales/investment expenses wedge
being imposed by Canada’s for-profit financial services industry
is simply too large. What, if anything, should Canada’s federal
and provincial governments do about this reality? At one extreme,
a caveat emptor approach leaves millions of Canadian workers caught
in this financial trap the impossible task of discovering their
own way out. At the other extreme, a benevolent dictator approach
would ban mutual fund investing altogether and force all workers
to save for retirement through a central low-cost government agency.
We favour a middle way: the “paternalistic libertarian”
approach currently in the process of being adopted in the UK. The
basic idea is to create a number of arm’s-length, expert,
pension delivery organizations, and then to automatically enroll
the entire non-covered part of the workforce into one of them. People
can elect to opt out if they do not wish to participate. A minimum
7% of pay contribution rate is projected to increase the median
income replacement rate for UK workers from 30% of working earnings
(from Pillar 1 social security payments) to 50% of earnings. A key
assumption in these calculations is that the pension delivery organizations
operate in the sole best interests of plan participants, with expense
ratios of 0.3%.12 Canada’s
governments successfully reformed an important part of the universal
Pillar #1 component of our pension arrangements in the 1990s (i.e.,
CPP/QPP). Our study indicates that they must now urgently turn their
attention to reforming the occupational part of our retirement income
system. Creating pension delivery organizations that are able and
willing to produce fair value for all Canadian workers will be a
critical element of this reform.
Ambachtsheer, Keith P., “Pension Revolution:
A Solution to the Pensions Crisis,” John Wiley & Sons,
Ambachtsheer, Keith P., “Beyond Portfolio Theory: The Next
Frontier,” Financial Analysts Journal, January-February,
Ambachtsheer, Keith P., Ronald Capelle, Hubert Lum, “Pension
Fund Governance Today: Strengths, Weaknesses, and Opportunities
for Improvement,”Working Paper, 2006, www.rotman.utoronto.ca/icpm.
Bauer, R., R. Frehen, H. Lum, and R. Otten, “Economies of
Scale, Lack of Skill, or Misalignment of Interest? A Study of Pension
and Mutual Fund Performance,”Working Paper, 2006, www.rotman.utoronto.ca/icpm.
Bogle, John C. The Battle for the Soul of Capitalism, Yale
University Press, 2005.
Mahoney, Paul G., “Manager-Investor Conflicts in Mutual Funds,”
Journal of Economic Perspectives, Spring 2004.
1. See IFIC website www.ific.ca.
2. See Bauer et al. (2006).
3. The Globefund.com database provides electronically accessible
Canadian mutual fund data beginning in 1996. Worldscope provides
global benchmark return data, from which Canadian equity market
indexes (e.g., large cap, mid cap, small cap) were created. The
CRSP database covers all U.S. mutual funds from 1962-2004, and includes
fund-specific variables such as expense ratios, fund flows, investment
4. Actually, the sequence is reversed for mutual funds, as the available
return data already has the MERs netted out. So here the sequence
goes from net return minus the relevant benchmark equals the mutual
fund NVA for that year. The MER is then added back to the NVA to
produce the mutual fund’s GVA for that year.
5.The Canadian equity mutual fund MER average of 2.75% comes from
the Globefund.com database, based on 2004 data. Different databases
(e.g., Investor Economics) produce somewhat lower MER averages (e.g.,
2.44%). However, a lower average MER estimate does not impact the
study’s basic conclusions, which are based on the comparison
is pension fund and mutual fund NVAs. Why? Note  above explains
that the mutual fund NVAs already have the correct MERs netted out.
So in Table 1, the average mutual fund NVA calculation of -2.60%
comes first. Then that number is grossed up by the 2.75% MER average
to produce the average mutual fund GVA estimate of +0.15%. If the
-2.60% had been grossed up by 2.44% instead, the mutual fund GVA
estimate becomes -0.16%, instead of +0.15%.
6. Calculations based on data in the CEM Benchmarking Inc. database.
for more information on CEM.
7. The expense ratios embedded in ETFs can be as low as 0.07%.
8. See 2006 survey by Pollara posted on the IFIC website www.ific.ca.
9. See Ambachtsheer (2005) and (2007) for more on information economics
and on market behaviour under conditions of informational asymmetry.
10. See Bogle (2005), page 167.
11. Astute readers will note that Table 2 does not display a calculation
that projects the significantly positive net excess returns Canadian
pension funds actually earned in the past, into the future. Doing
so would have increased the calculated value-losses of the average
mutual fund investor even more. See Ambachtsheer et al. (2006) for
research on pension fund governance and its potential impact on
pension fund returns.
12. See Ambachtsheer (2007), Chapter 43.
— Keith Ambachtsheer, director of the Rotman International
Centre for Pension Management at the University of Toronto, and
Rob Bauer, professor of finance at the University of Maastricht
in the Netherlands.
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