Coins in Stacks

From our Canadian Bureau: A Raise for Your Money Manager?

Coins in Stacks

I bet investors take most pieces of mail regarding mutual fund unitholder votes and file them under "G" for garbage. Frankly, oftentimes the issue being voted upon has no material impact on unitholders. However, November 14, 2000 marks an important day for Dynamic Power Canadian Growth unitholders, when a vote will be held that goes straight to their bottom lines.

Dynamic unitholders will be asked to approve the merging of Dynamic's Power Canadian fund into its sister Dynamic Power Canadian Growth fund. No problem there: it makes perfect sense to merge two similar, or identical, funds. However, another issue on the voting ballot will be a proposal to introduce a performance-based fee to the Power Canadian Growth fund, which would effectively raise the cost of holding this existing fund.

Dynamic Power Canadian Fund

Net assets (Canadian dollars): $598 million
Inception date: June 1998
Management fee: 2.0%
Distributions: Annually
Expense ratio: Capped at 2.25% (excluding performance fees)

Source: Dynamic Power Canadian Fund Prospectus, September 2000 [/:Author:]
Dynamic Power Canadian Growth Fund[/:Author:]

Net assets (Canadian dollars): $862 million
Inception date: August 1985
Management fee: 2.0%
Distributions: Annually
Expense ratio: 2.61%

Source: Dynamic Power Canadian Growth Fund Prospectus, September 2000

History

When Dynamic first launched its growth-oriented Power family of funds, it scooped Canadian stock-picking veteran Rohit Sehgal (formerly of London Life Canadian Equity) to run the show. The Power Canadian fund was launched with Sehgal at the helm and shortly after, he took over management of the old Dynamic Canadian Growth (now known as Power Canadian Growth). Since that time, Dynamic has indicated that it intends to merge the two funds, since their portfolios are virtually identical. That makes sense, but while the stock picks are identical, the funds themselves have always had an important difference. Both funds have a management fee of 2%, but the Power Canadian fund tacks a performance fee on top of the standard annual price tag.

Performance gap

For the year ending December 31, 1999 the Dynamic Power Canadian returned 50.7%, while Dynamic Power Canadian Growth gave investors a healthy 57.9% return. Why such a large difference? There are a couple of reasons. The performance fee on the Power Canadian fund amounted to 2.18% of assets for the year - sending its MER for the year to about 4.58%, including GST (goods and services tax) and other taxes. (Total performance fees on this fund are capped at 3% of average net assets.) By contrast, the Power Canadian Growth had total fees of 2.68% during 1999, including GST and other taxes. So net differences in fees explain 1.9 percentage points of the 7.2 percentage point gap.

Strong cash flows coupled with a strong market probably explain the remainder of this large performance gap. When markets are soaring, as they were during 1999, a fund's performance will be higher, all else equal, if it has all of its money invested, compared to a cash-heavy fund. It was that exact combination of factors that substantially explains the remainder of the return difference. During 1999, investors poured C$265.3 million into the Power Canadian fund - 319% of assets at the start of the year. Over that same period, Power Canadian Growth fund drew C$81.0 million from investors. That figure represented a strong, but more modest, 17% of the fund's assets at the beginning of the year. It appears that cash piled up quickly in the Power Canadian fund, while its sister remained more fully invested during a white-hot stock market.

Performance fees explained

Most managers with performance fees charge a flat management fee, then add a "bonus" for outperforming a stated benchmark. Power Canadian pays its manager a performance bonus for each year that it outperforms the TSE 300 Total Return Index. The bonus is equal to 10% of the outperformance. During 1999, Power Canadian returned about 53.5% prior to calculating the performance bonus, while the TSE 300 returned 31.7%. The performance fee was calculated as follows:

0.10 x (0.535 - 0.317) = 0.0218 = 2.18%

The fee is not charged if the fund and the TSE 300 both post negative returns. If the fund otherwise underperforms the TSE 300, a negative fee results and is carried forward to offset future performance fees.

A history of unitholder votes

Canadians have a mixed track record when it comes to unitholder votes. Back in February 1996, First Marathon Securities held a unitholder vote to increase the management fee from 2% to 2.25% on the no-load Marathon Equity fund - a resource-heavy small cap fund. At the time, it didn't seem like an outlandish proposal, since the fund had a stellar long-term track record in both up and down markets - giving investors dizzying returns in hot times but good downside protection during weaker markets. A whopping 66% of unitholders squashed that proposal. If given a choice, it makes sense to opt for the cheaper option, all else equal.

In June 1998, fund manager BPI held a vote to increase fees on its Dividend Income fund, which had its MER capped at 1.00% at the end of 1996 - also by unitholder vote. The information circular estimated that the fund's MER without the cap would be 1.28%. Unitholders of the BPI Dividend Income fund (now known as CI Signature Dividend Income) voted to lift the cap and let the fund pay for 100% of its fees, which amounts to about 1.50% these days. In other words, it was likely enough that unitholders ignored the information package and voting information. That's the only logical explanation I can think of for unitholders to vote in favor of a fee hike.

How to vote

When investors receive the information package for an upcoming meeting, they owe it to themselves to read the material. Ignorance can cost money. It is not mandatory to attend the Toronto meeting to vote. Existing unitholders of the Power Canadian Growth fund really don't have any incentive to vote for a fee increase. If awareness of the issue and its potential impact is raised, investors can save themselves, and thousands of other Canadians, significant dollars in subsequent years.

Pros and cons of the merger

Existing unitholders of the Power Canadian fund would definitely benefit from the increased asset size to reduce the impact of cash flows into and out of the fund. However, unitholders don't need a vote to make a change. Switches can be made to the larger and cheaper Power Canadian Growth fund at any time. (Of course tax consequences of making such a move could prove prohibitive in many cases.) While there are advantages of merging the two funds' assets, there is absolutely no financial incentive for unitholders to approve the introduction of a performance fee to the Power Canadian Growth fund.

Dynamic's advantage is that it will have the assets of both funds earning the firm higher fees over time. However, if the proposal gets turned down, the fund likely won't change. After all, Dynamic has a vested interest in continuing to keep the fund's C$862 million in assets well-managed - and unitholders have a vested interest in minimizing the costs of their investments.

Don't get me wrong, I love the idea of performance-based fees, since it more closely aligns the money manager's interests with that of its investors. However, I'm not a fan of charging such fees on top of an already healthy management fee, but Dynamic is not unique in this regard. Virtually all retail mutual funds that charge performance fees have a generous 1.75 to 2% fee as a fixed annual base cost.

Last year, Franklin Templeton tried to merge their two balanced funds, leaving the more expensive Canadian Asset Allocation as the surviving fund. Media attention to the issue caused the firm to pull that issue from its meeting agenda, and it has not since revisited the issue publicly. That's my goal with this week's article: raise awareness of the pending cost increase and prompt investors to take action by casting their votes. After all, it is your money.