Beating the 5 year bond can be tough for some mutual funds

As of last Thursday, a five year Canadian government bond was trading at an implied yield of 4.28%.

If you wanted a similar return over a five year period, you could have invested in the following mutual funds (data from Saturday’s Globe and Mail):

AGF International Value: 4.68%

CI Canadian Bond Fund: 3.70%

CI Value Trust Corporate Class: 2.32%

Fidelity Global – B: 6.40%

Mackenzie Ivy Canadian 5.32%

Mackenzie Ivy Foreign: 3.11%

Mackenzie Ivy Growth & Income: 5.43%

SEI U.S. Large Co. Equity 4.34%

In the case of Mackenzie’s Ivy Foreign Equity fund, for example, the management expense ratio is a whopping 2.46%, which means on the $2.73 billion under management, the team (Mackenzie and the stock brokers that placed the fund) earned more than $335 million in fees over the five year period (assuming AUM were stable). That seems like a herculean amount of effort to earn less than what the federal government would offer in annual interest for a Triple A-rated security.

AGF’s International Value Fund hasn’t had much more success, although it did beat the 5 year bond. Aggregate fees over the five year period amounted to $476 million for that 4.68% return. And the Globe and Mail gives it a “three star” rating?

Here’s an idea. Let’s put in a new term into every equity mutual fund. If the 5 year performance figure is below a government bond of a similar term, a portion of the management fee should be returned, either back to investors or into the fund itself. In the venture debt, venture capital and private equity world, we call it the preferred return. If we don’t get you X% (somewhere generally between 6% and 8%), there are no profits to be shared. If there are “excess returns”, the 80/20 idea kicks in.

Assuming that the PE industry’s 2% annual management fee is an accurate reflection of what it costs to actively manage an equity (or similar) fund, Mackenzie Ivy investors would save 46 bps a year in fees under a PE structure. This change would push a 3.11% “Globe Two Star” performing fund up modestly to 3.57%, but that’s a 15% improvement in annual performance.

(What’s it take to fall to “one star” status, btw?)

The 2% fee involves private equity and VC types sitting on boards, going to weekly management meetings, flying to California to hire a new CEO, etc. A far higher impact role than a money manager normally plays. It could be argued that 2% is high for a more tranquil equity mutual fund management role.

Nevertheless, paying for performance isn’t a novel idea, and something the fund industry should embrace. What’s IFIC’s argument against the idea?

MRM