Cage match

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   By Guest Blogger Ryan Lewenza

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When I was a young tike my pals and I liked to play with WWF wrestling figures. We had all the characters including Hulk Hogan, Randy Savage, and my personal favourite, George ‘The Animal’ Steele (that’s his smiley face above). Our favourite thing to do was a ‘cage match’, where we all had our chosen wrestlers, and we would duke it out in a winner takes all match.

Well, today we have a cage match, winner take all situation but between mutual funds and exchange traded funds (ETFs). In this corner, weighing in at an expensive 2% management expense ratio (MER), we have the old and well past their prime, Canadian mutual funds. And in the other corner, we have the low-cost and fresh new contender, ETFs. Let’s get ready to rumble!

A bit of history first. The first mutual fund was created in the US back in 1924. Here in Canada the initial mutual fund started in Montreal in 1932 and was a groundbreaking event. For the first time retail investors could easily access professionally managed, diversified products. Since that day Canadian investors have flooded into these investment products, with a total of $1.9 trillion invested in Canadian mutuals.

The first ETF was actually created right here in Canada in 1990, which then led to the launch of the premier US ETF – the SPDR S&P 500 ETF Trust – which is today the largest in the world with over US$500 billion in assets under management (AUM).

Well, a lot has changed in recent decades, as investor knowledge improves and there is a greater participation in the financial markets, with many investors moving away from mutual funds and into ETFs.

Here in Canada, we’ve seen a massive increase in AUM and adoption of ETFs as investors increasingly move from mutual funds and into them. Since 2014, AUM in ETFs has surged from $77 billion to $382 billion or a fourfold increase. Mutual funds have continued to see a rise in AUM but at a much slower pace – less than a doubling of AUM since 2014.

There’s no doubt that mutual funds continue to be the main investment vehicle for Canadian investors, but that is changing, and we see investors increasingly directing more of their savings into the ETF space.

AUM of Canadian mutual funds and ETFs

Source: Investment Funds Report 2023

First, fees are so critical to one’s investment performance and outcomes, and here’s where ETFs really shine. Canada, unfortunately, has the distinction of having some of the highest mutual fund fees in the world. Yippee!

A study by The Society for Financial Studies, which examined over 46,000 mutual funds across 18 different countries, foundCanada ranks the highest in fees paid by investors. A big reason for this is the concentration of Canadians’ savings and wealth at the big 6 Canadian banks. There’s a reason why our banks make billions of dollars a year in profits, with these high management fees contributing to the bottom line.

The table below shows the average management fee for Canadian equity mutual funds is 1.96%. In the US the average equity mutual fund fee is 0.62%. While mutual fund fees have come down in recent years, we continue to pay some of the highest fees in the world.

Mutual fund fees around the world

Source: Mutual Fund Fees Around the World, The Society For Financial Studies

To show the impact of these higher fees, a $500,000 portfolio invested for 20 years and earning a 7% return, the Canadian portfolio with the high 1.96% fee would see the portfolio grow to $1.336 million. The US portfolio with the lower 0.62% fee would see the portfolio grow to $1.722 million.

Now that analysis just compares Canadian to US mutual fund fees. Let’s take it one step further and compare mutual fund fees to ETF fees. I calculated the average MER of the main Canadian equity mutual funds from the three largest Canadian banks and compared it to the BMO S&P/TSX Capped Composite Index ETF, which is a proxy for the TSX.

The average MER for the Canadian equity mutual funds (from these three banks) was 2.15%. The BMO TSX ETF fee is just 0.06% or 6 bps. So, the BMO ETF is 97% cheaper than its mutual fund comparable. What does this work out to long-term?

Using the same analysis of a $500,000 portfolio invested for 20 years and earning a 7% return, the ETF portfolio would grow to $1.913 million versus the mutual fund portfolio of $1.289 million. Not sure about you, but I would much rather have the extra $624,004 versus the banks having it!

Impact of paying higher MER fees

Source: Turner Investments; Analysis: $500,000 invested at 7% over 20 years

Second, the performance of many mutual funds is poor, in large part due to the high management fees they charge. Sure, there’s the occasional rockstar portfolio manager that makes actual bets and investment calls where they can consistently outperform the markets. But they are few and far between.

For this we highlight the annual report from Standard and Poors’ called the SPIVA report. The report measures every actively managed mutual fund and compares them to their benchmark. For example, if you’re a large cap Canadian stock portfolio manager than your benchmark, or what your evaluated against, is the TSX.

Well, 96% of all actively managed Canadian equity portfolio managers underperform their benchmark/TSX over a 10-year period. The main reasons that most active portfolio managers underperform is a combination of poor stock picking, excessive trading/expenses and the high fees they charge.

Percentage of funds underperforming benchmarks

Source: SPIVA

Finally, another major benefit of ETFs is the expansive universe of ETF options. As ETFs have grown in popularity and size, ETF providers have launched new and interesting products giving ETF investors more options to construct portfolios. Some of these include sector ETFs, commodity ETFs, covered call strategies and leveraged ETFs to name just a few.

As a portfolio manager, building balanced and diversified portfolios for clients, one of the biggest advantages of ETFs is all the different ETFs available to choose from. For example, we’re bullish on South Korean equities and Canadian dividend paying stocks over the next 12-18 months and there’s numerous ETFs that we can choose from to get these exposures.

I think we know who came out on top from this cage match. The lower fees, better performance and greater selection is why Garth and Turner Investments have gone ‘all-in’ on ETFs.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.