Chapter 10

Enhancement 1: Reducing Fees

You will recall that Nick and Susan invested their RRIF assets in mutual funds and paid a total annual fee of 1.8 percent. This level of fee, which is also known as the management expense ratio (MER), is fairly typical if one invests in a blend of actively managed equity and fixed income mutual funds in the retail market.

When your total expected annual return is just 5 percent or so, you shouldn’t be giving up 1.8 percent in fees. That would leave you with a return of only 1 or 2 percent a year after inflation, less if your investments don’t do too well!

Management expense ratio (MER) is the total percentage of assets the investment company charges you in a given year to cover investment, administrative, and other sales-related charges. For example, an MER of 1.8 percent on assets of $500,000 results in annual expenses of $9,000. In the case of mutual funds, these fees are quietly deducted from the assets. Various series of funds are available from each company with different fee levels depending on (a) how much you are investing and (b) whether you are working with a professional advisor who charges you an additional fee.

Enhancement 1 involves bringing the MER down from 1.8 percent to 0.6 percent a year. As described later on, there are at least a couple of ways this can be accomplished. The way you choose depends on the extent of your investment knowledge and how much time you want to spend managing your money.

We will assume that Nick and Susan go with a robo-advisor and end up paying 0.6 percent a year, including both the robo-advisor fee as well as the cost of the advisor’s exchange-traded funds (ETFs).

The ETFs I have in mind are passively managed investments, meaning that they track an external index such as the S&P/TSX index. ETFs make no attempt to beat the market, which is just as well since most active managers fail to do so but charge a hefty fee to try. ETFs are increasingly popular because the fees tend to be much lower than is the case with active management. In addition, ETFs are easy to buy and sell.

Passive management in an investment context means an investment that is meant to mimic an index that represents the entire market or some subset of the market. There is no attempt to beat the market with passively managed funds. The alternative is active management, whereby the manager regularly buys and sells securities in an effort to beat the market.

The robo-advisor helps Nick and Susan put together a simple ETF portfolio as shown in Table 10.1. (I should add that the ETF examples shown in the table could easily have come from a different company. Blackrock and BMO are excellent institutions, but I am not claiming that they are better or worse than their competitors.)

Table 10.1. Fees for a typical ETF portfolio

Asset class	Example of an ETF for that asset class	% of total portfolio	MER
Canadian stocks	BMO S&P/TSX Capped Composite Index ETF	20%	0.06%
US stocks	iShares Core S&P 500 ETF	20%	0.10%
International stocks	iShares Core MSCI EAFE IMI Index ETF	20%	0.22%
Canadian bonds	iShares ESG Canadian Aggregate Bond Index ETF	35%	0.20%
Cash equivalent	BMO Ultra Short-Term Bond ETF	5%	0.17%
Total portfolio		100%	0.1545%

The above portfolio has an annual MER of just 0.1545 percent. Yes, that is less than one-sixth of 1 percent! In addition, their robo-advisor charged another 0.4 percent, bringing the total annual fee to a little under 0.6 percent. It could have been even less than that since at least one robo-advisor charges just 0.25 percent a year.

On the other hand, the total annual cost could have easily topped 0.6 percent if Nick and Susan had chosen a traditional advisor who charges a higher annual fee, such as 1 percent a year. They might have taken this route if they needed a little more hand-holding but, frankly, I don’t think that the function of setting and maintaining one’s asset mix is worth more than 0.4 percent a year. I am not saying that the model asset mix in Table 10.1 is optimal, but it is at least adequate. No one could tell you for sure whether another asset mix would be better.

If Nick and Susan did decide to go to a traditional advisor, they should have no qualms about pushing back on fees. An advisor was charging a friend of mine more than 2 percent a year (including underlying charges for the mutual funds). When I suggested to my friend that he consider a robo-advisor, the advisor offered to slash the total cost to just 0.9 percent, with no change in the portfolio or in the service level he provided!

By the way, the Thompsons’ robo-advisor will have to engage in some buying and selling of the ETFs to keep the same asset mix over time. It is not uncommon to see one asset class (such as Canadian stocks) rise in value much faster than another (such as Canadian bonds), and if the portfolio is not rebalanced, the asset mix will quietly drift. This is not only dangerous; it is a missed opportunity. The Canadian Institute of Actuaries (CIA) confirms the benefits of rebalancing the asset mix on a regular basis (such as once a quarter). Over the long run, this practice can add up to 50 basis points to the annual return, which is as close as you will ever come to a free lunch in the investment world.

Do ETFs Perform as Well?

You might be wondering if Nick and Susan are giving something up by paying so little for investment management. It defies the notion of getting what you pay for. Can passive management using ETFs really match the performance of active fund managers?

You would think there would be a clear and concise answer to this question, but that isn’t the case. Certainly, the professional investment managers will claim to add value, but they are hard-pressed to show it over the long term.

Burton Malkiel famously claimed that a monkey throwing darts could select stocks as well as investment managers.8 A serious investment journal tested this claim once and reported the results in a paper that was published in 2013.^a The authors found that inverting the algorithms behind popular, well-established stock-picking strategies provided equal or better performance. They further concluded that the same is true with any random stock-selection strategy. In other words, you could follow a given approach or you could do precisely the opposite, and in the long run, the result would essentially be the same!

A good source of hard data on the subject is the SPIVA Canada Scorecard, which is published every six months. SPIVA stands for Standard and Poor’s Index Versus Active and as the name suggests, SPIVA reports actively managed investment funds versus their benchmarks. Table 10.2 shows the percentage of managers in each major category who outperformed their respective benchmark in calendar years 2016 and 2018.

Table 10.2. Percent of managers outperforming their benchmark

	2016	2018
Canadian equity	17.3%	23.1%
Canadian dividend and income	19.4%	34.8%
US equity	28.4%	21.4%
Global equity	24.1%	22.5%

Source: SPIVA Canada scorecard

I chose 2016 and 2018 as examples of years when the markets did especially well and especially poorly, respectively. The obvious message from Table 10.2 is that the average investment manager cannot consistently beat the index in good times or in bad. This is quite astounding given that the managers do a great deal of research on the economy as well as on individual companies and try to do their best to avoid the losers.

The years 2016 and 2018 are not anomalies. As SPIVA Canada points out in their Scorecard report, more than nine funds in ten underperformed their benchmarks over the most recent ten-year period.

While the SPIVA findings are rather compelling, other sources show the median active fund manager doing a little better. For instance, Morneau Shepell maintains a quarterly survey that they call the Performance Universe of Pension Managers’ Pooled Funds. This is available online for free at morneaushepell.com by clicking on Knowledge & Insights. The most recent survey shows the median fund manager more or less matches the benchmark return. While this seems to conflict with SPIVA, there are three differences between the two sources. In the case of the Morneau Shepell survey:

1. The fund manager’s fees are not included; these can be significant.
2. Not all fund managers are in the survey; it seems plausible that the ones who are performing especially poorly decline to participate.
3. There is no correction for survivorship bias. This term refers to the fact that the survey shows only the funds that are still there at the end of the period, i.e., the survivors. There may have been more funds at the beginning of the period that dropped out or even closed their doors because of poor results.

At this point, most readers should be convinced that active management doesn’t add value or at least not enough value to justify the fees. But let’s be fair and give the active managers one more chance. Let’s suppose for a moment that the average active manager doesn’t add value but maybe the top 10 percent of managers do. Maybe it’s just a question of finding the few managers who are consistently outstanding and putting your money with them.

Alas, there is no proof that some investment management firms are consistently better than their peers. Consider the managers of domestic equity funds who were in the top quartile as of September 2017. According to a SPIVA Canada report entitled Does Past Performance Matter? The Persistence Scorecard, only 8 percent of them were in the top quartile two years later. This result is barely different from random chance, which would predict that 6.25 percent (25 percent of one-quarter) would still be in the top quartile in the later period.

What is remarkable is that the investment management community has managed to convince so many investors that they can “do better” than the benchmarks. (As an aside, investors tend to exhibit the same unfounded optimism about beating the odds, as do newlyweds who ignore dismal statistics on divorce.) The data suggests they cannot, and the reason comes down to the efficiency of the markets; i.e., the markets reflect all available information in the current prices of securities. Moreover, the markets do this so quickly that fund managers cannot act fast enough to take advantage of a temporary mispricing of a particular security.

Impact of Reducing Fees

If Nick and Susan reduced their investment management fees down to 0.6 percent from the outset (instead of 1.8 percent), Figure 10.1 shows how much more income they would be able to generate. Simply reducing fees adds nearly three more years of RRIF income.

Figure 10.1. After Enhancement 1, reducing investment fees

This is the same as Figure 9.1 except investment fees are reduced to 0.6% a year. RRIF income lasts nearly three years longer as a result.

It is important to note that Nick and Susan enjoy this improved result without getting investment returns that are any better than they had in the previous scenarios; they are simply giving up less of their money to financial advisors.

Although the financial picture has improved for Nick and Susan as a direct result of reducing their investment fees, their actual income still falls well short of their income target in their latter years. The next enhancement will eliminate most of the shortfall.

Takeaways

1. Reducing investment fees can significantly increase one’s retirement income.
2. Actively managed funds are more expensive than passively managed funds, like ETFs, but with no evidence that they add value when you take fees into account.
3. Using passively managed ETFs, the total annual investment fee can be brought down to about 0.45 to 0.6 percent if you use a robo-advisor, less if you do it all yourself.

8 Malkiel is the author of the brilliant book A Random Walk Down Wall Street, first published in 1973 by W.W. Norton & Company.